Bank of America Merrill Lynch Research Report - RBI: 3 burning Questions for Tuesday

Bottom line: Dovish Tuesday to signal further rate cuts

We expect the Reserve Bank of India (RBI) governor Raghuram Rajan to turn even more dovish this Tuesday than the January 15 statement. He will likely cut rates by 25bp again in April. After all, banks are unlikely to cut policy rates till the slack season sets in April-September. Three questions arise. Will the RBI signal a long rate cutting cycle? We expect it to edit the January 15 policy to commit “…further easing barring renewal of inflationary pressures…” from “…key to further easing are data that confirm continuing disinflationary pressures…” Second, will it again cut on Budget Day? We expect it to drop the phrase “…including outside the policy review cycle…” to signal normalization of monetary policy actions. Will the RBI continue to recoup FX reserves? Yes, we expect Governor Rajan to raise concerns about contagion when the Fed raises rates (in September, according to our US economists). The RBI will also likely highlight his concerns about ‘competitive monetary easing’ – that we fully share - especially after last week’s ECB QE. Do read our 2015 India report here

#1. Will RBI signal rate cutting cycle?

125bp by April 2016 Will the RBI commit a long rate cutting cycle? We expect it to provide a stronger assurance of a rate cutting cycle on Tuesday in view of softening commodity prices and sluggish recovery. It could, for example, edit the January 15 policy to commit “…further easing barring renewal of inflationary pressures…” from “…key to further easing are data that confirm continuing disinflationary pressures. Also critical would be sustained high quality fiscal consolidation as well as steps to overcome supply constraints …” This would reinforce

This would reinforce the RBI’s view that “… (deflationary) developments have provided headroom for a shift in the monetary policy stance… once the monetary policy stance shifts, subsequent policy actions will be consistent with this stance…”

Falling core suggests growth below potential growth in new GDP series: We also await RBI’s views on the government’s new 2011-12 GDP series that has revised FY14 growth to 6.9% from 4.7%, largely by extending data coverage of the informal/unincorporated sector. Pronab Sen, chairman, National Statistical Commission, of course, has long maintained that the 2004-05 GDP data was underestimating industrial growth. Based on the new methodology, we are tracking FY15 growth at 6.6% (up from 5.5% under the old methodology). We will firm up our numbers after we get further information on release of quarterly data on February 9 and a new manual in end-February. Do see our new GDP report here.

The key question for monetary policy, of course, is what is potential growth in the revised GDP series? If growth is well below (near) potential, monetary policy should ease aggressively (only marginally). In the 2004-05 series, our forecasted 5.5% FY15 growth was well below our estimated 7-7.5% potential. As back data are not available for the new 2011-12 series, potential growth, based on it, remains an open question. With core inflation steadily coming off, it can, at least, be inferred that the economy is still operating well below potential.

#2. Budget day cut? RBI to drop inter-meeting option

Second, will the RBI again cut on Budget Day? We expect it to normalize monetary policy actions by dropping the phrase “…including outside the policy review cycle…” to signal that the next move would be in the April policy rather than inter-meeting, say, on Budget day on February 28. Although we were ahead of the Street in calling for a February 2015 rate cut, we strongly feel, as self-confessed hawks, that intermeeting actions should be limited to emergencies in the FX market. At the same time, if the inter-meeting cut option is retained, we would expect a 25bp cut on Budget day after Finance Minister Jaitley sets a 3.8-4% of GDP fiscal deficit target (somewhat higher than the pre-announced 3.6%) for FY16 after meeting his 4.1% of GDP FY15 fiscal deficit target (Table 1). A bit of good news is that the government has sold 10% of Coal India stock on Friday.

Fiscal concerns overdone. We do not really lose sleep over the fiscal deficit. The Center's fiscal deficit, at 4-4.5% of GDP, is already the lowest in 35 years (barring the upcycle years of FY04-08) (Chart 3). We are thus not able to understand why some segments of the market wanted to make the fig leaf of "fiscal consolidation" a pre-condition for monetary easing at 8% RBI repo rate when growth is so far below our estimated 7-7.5% potential. Against this backdrop, we are glad that the RBI did not unnecessarily put off easing. Lower rates will revive growth, improve tax buoyancy and improve the fiscal position a la FY04-08 (Chart 4). Do read our last fiscal report here.

#3. Fed hikes? RBI to recoup FX; hold Rs60-65/USD

We continue to expect Gov Rajan to recoup FX reserves to fight possible contagion when the Fed raises rates in September. We expect him to talk about his concerns about monetary easing, especially after last week’s ECB QE. If it consistently buys FX, our BoP forecasts that the RBI can reach 10 months' import cover by March 2016, well above the critical eight-month import cover needed for INR stability (Table 2 and Chart 5). This assumes oil at US$55/bbl in FY16: US$10/bbl swings US$8bn on the current account deficit. Do read our reports on ECB QE here and competitive monetary easing report here.

On balance, we expect the RBI to hold Rs60-65/USD unless the US Dollar appreciates, say, another 20% hereon. After the ECB QE, our FX strategists have changed the EUR/USD forecast to 1.10 by end-2015 and 1.05 by end-2016, from 1.20 and 1.15 respectively. Needless to say, they expect the INR to outperform within the EM FX complex here.

We continue to see a 3-step FX policy from the RBI:

• Rs 60-62/USD: RBI will buy FX as it is doing;

• ​Rs 63-64/USD: It will likely offer token defense selling, say, US$500mnUS$1bn, as it did last month. The RBI should ideally want to hold Gov Rajan's preferred Rs60-62/USD zone. At the same time, it will not spend too much of precious FX at a time the INR has outperformed most BRIC/TIM currencies.

• ​Rs 65/USD: We see full-scale FX intervention of, say, US$15bn.

Finally, appreciation since January 15 supports our standing view that RBI rate cuts typically support INR. This is because the FII equity portfolio, at US$330bn, is 6x the FII debt portfolio. In addition, July 2013 shows that expectations of MTM gains on perceived rate peak-off led to FII debt inflows.

New monetary policy framework: clarity expected

We seek clarity on the RBI's decision to adopt a monetary policy framework in consultation with the government. Monetary policy decision making is to be entrusted to a monetary policy committee (MPC) in the next fiscal. Gov Rajan has told the media that discussions are ongoing with the government regarding setting up the MPC that would use the collective wisdom of a collegiate system to make the monetary policy decision. He also noted that the government is comfortable with the Urjit Patel committee's recommended 4% +/- 2% target inflation band beyond 2016.

We expect the composition of the MPC will be an amalgamation of the Justice Sri Krisha's FSLRC and the Urjit Patel reports. The FSLRC report recommended a total of seven members. Of these, the Chairperson and one executive member of the board will be internal members. Of the remaining five external members, 2/5 are to appointed by the central government in consultation with the Chairperson (RBI Governor) and 3/5 are to be appointed solely by the government. The government will also have a non-voting representative on the MPC. On the other hand, the Urjit Patel report proposed three internal and two external members. Internal members would be Chairperson (RBI Gov), Vice-Chairman (RBI Deputy Governor in-charge of monetary policy) and RBI's executive director in-charge of monetary policy. Both the external members are to be selected by the Chairman and the Vice-Chairman.

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