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Bank of America Merrill Lynchs' India Economic Watch: 3 Reasons Why Feb RBI Rate Cut is on Track

Jan 06, 2015   16:37 IST 

Bottom line: 2015 to see lower rates to support growth

Happy 2015! We continue to expect RBI governor Raghuram Rajan to cut rates 25bp on February 3. In our view, inflation is well set to achieve the RBI's 8% January 2015 and 6% January 2016 CPI inflation targets. What would change by February? Gov Rajan will likely have the confidence of meeting his 8% January 2015 target. We are now tracking December CPI inflation at 5.5%. There is also greater visibility of a close-to-normal winter wheat crop that should contain agflation. Sowing is picking up after a delayed start due to late rains, adjusted for base effectsof last year's bumper crop. Finally, there should be greater comfort that 'imported' inflation is abating as the Fed rate hike expectations (September BofAMLe) keep global commodity prices in check. Dated Brent has fallen to US$55/bbl. Should the RBI wait to cut 50bp in April after the Budget as some suggest? We can only quote from Sant Kabir's dohes/couplets in response: "...kaal kare so aaj kar, aaj kare so ub..." This translates to: "...tomorrow's work do today, today's work now..." Do read our last RBI report here


Sant Kabir: Medieval Indian saint and poet who preached oneness of God.


1st RBI rate cut February 3, 75bp in 2015

We continue to expect Gov Rajan to cut rates 25bp on February 3 (Chart 1). The December policy was dovish in line with our expectation that the RBI will find the balance of risks to its January 2016 6% inflation target to be neutral relative to the September policy that stated upside risks. It stated: "... if the current inflation momentum and changes in inflationary expectations continue, and fiscal developments are encouraging, a change in the monetary policy stance is likely early next year, including outside the policy review cycle..."


Should the RBI wait to cut 50bp in April after seeing if the Budget sticks to fiscal consolidation? We do not see how what is to be gained by putting a 25bp RBI rate cut in February. The BJP's Election Manifesto has made a commitment to fiscal consolidation. Media reports suggest that Finance Minister Jaitley will likely target a conservative 3.8-4% of GDP fiscal deficit, marginally above the unduly strict 3.6% projected by former FM Chidambaram.


Lending rate cuts key to recovery

We continue to believe that lending rate cuts hold the key to recovery. Our lead indicators suggest that December quarter growth could fall below 5% if agricultural growth is 0% (Table 1). A RBI rate cut in February will likely lead to a lending rate cut only after the slack season sets in April and support growth after September. Although we fancy ourselves hawks, we cannot but acknowledge that RBI tightening since 2012 has become increasingly counter-productive given our belief that much of inflation is "imported". Against this backdrop, we agree with the Finance Minister Jaitley's view that: "...the cost of capital is one singular factor which has contributed to the slowdown in manufacturing..."


In our view, high rates are proving a disincentive to produce and invest. While the consumer faces CPI inflation, the producer's pricing power is better measured by non-food manufacturing WPI inflation. On ex post basis, real lending rates, at 12.5%, are at historical highs relative to average of 8.8% since 1997 (Chart 2). This is clearly hurting recovery (Chart 3). The MoF's mid-year review arrives at a similar conclusion using a real policy rate and a monetary conditions index. It concludes that "... the similarity of real rates today and in recent previous episodes (2004 and 2007) is especially striking because then the economy was close to overheating while today it is just beginning to recover..."


We are not able to understand how some market participants claim that growth will rebound on "project clearances" or even bizarre, "sentiment", without the cost of capital coming down. Has any cycle turned up since the 20th century with high interest rates? Although much is made of how the last cycle was driven by higher investment, it is often forgotten that this itself was driven by Gov Jalan's sustained monetary easing (Chart 4).


#1. Inflation to meet RBI's 8% Jan 2015 target

What would change by February? Gov Rajan will likely have the confidence of meeting his 8% January 2015 target. We are tracking December CPI inflation at 5.5% (Chart 5). January CPI inflation should come in around 6%. Table 2 shows that food prices are rising in December and January primarily on account of reversal of yoy base effects in vegetable prices, even though prices have stabilized on mom basis. However, pulses’ inflation continues to be elevated with below normal rabisowing atop a poor kharif harvest.


#2. Relatively ok wheat crop to contain agflation

There is greater visibility of a close-to-normal winter wheat crop containing agflation (Tables 3-4). Sowing has picked up after a delayed start due to late rains, adjusted for base effects of last year's bumper crop.


Oilseed cropping is also lagging but this is not likely to pressure agflation. This apparently reflects the disincentive from cheaper imports due to soft CPO prices. In fact, the government has just raised import duty on crude and refined edible oils by 5% recently to incentivize oilseed farmers. A 5% increase in edible oils increases CPI inflation by 20bp.


The fall in pulses sowing poses a risk. We estimate that a 5% change in pulses' prices impacts CPI inflation by 13bp.


A relief is rivers are running at close to normal levels after late rains (Table 5).


#3. Fed rate hike expectations check 'imported' inflation

There should be greater comfort that 'imported' inflation is abating as the Fed rate hike expectations (September BofAMLe) keep global commodity prices in check. In fact, Dated Brent has fallen to US$55/bbl with the OPEC refusing to cut production. Note, our numbers are based on our oil strategists' forecast of US$77/bbl in 2015. That said, our 6% January 2016 forecast holds good up to US$105/bbl. Do read our 6% inflation report here


FX reserves, not rates, key to INR stability

Doesn't the RBI need to hold high rates to support the INR at a time of stronger US Dollar? Not really, in our view, with Gov Rajan recouping FX reserves. Experience suggests that high import cover – rather than high rates – hold the key to INR stability India (Chart 6). Our FX strategist, Adarsh Sinha, sees Rs62/USD in March 2015. The INR would appreciate (depreciate) when the RBI cuts (hikes) rates. That is because the FII equity portfolio, at about US$330bn, that responds to growth, is 6x the FII debt portfolio, that may respond to higher rates. In fact, July 2013 shows that expectations of MTM gains on perceived rate peak off have been a bigger driver for FII debt inflows. In any case, the rate differential with the Fed, at 800bp, is already far higher than the average 460bp since January 2003 (Chart 7). Do read our last FX report here.


Token resistance at Rs62-63/USD

We continue to expect the RBI to continue to mount a token defense at Rs62-63/USD levels, selling, say, US$500mn-US$1bn, as it is doing. It is only at Rs 65/USD that we see full-scale FX intervention of, say, US$15bn. 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 (Chart 8).


In our view, the RBI may not be required to exert itself too much if the US Dollar settles at 1.20-.25/€ as our FX strategists expect. With US Dollar strength pulling down oil prices in US Dollar terms, there is a natural offset. Further, we expect corporate FX loans and bonds (of US$5.6bn) maturing in 1Q15 to be rolled over (Chart 9). If there is any stress, the RBI will likely elongate its forwards with banks as well.


Fiscal consolidation on track

Can fear of fiscal slippage be a reason to hold back RBI rate cuts till the February 27 Budget? We really do not see why. First, Chart 10 shows that 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). Given that growth is far below our estimated 7.5% potential, we welcome the Government's decision – as reported in the media – to relax the FY16 fiscal deficit target to 3.8-4% of GDP from 3.6%. Our estimates in Table 6 show thatFY16 fiscal deficit will come out to Rs5750bn or 4% of GDP, which would result in a net G-sec borrowing program of Rs5350bn. Do read our last fiscal report here.


Second, any overshoot of the 4.1% of GDP FY15 fiscal deficit target would be essentially statistical, as the Center has a buffer in the form of a Rs 1,284bn surplus with the RBI (as of March 31 2014) to protect net borrowing. In any case, MoF appears to want to stick to the 4.1% of GDP fiscal deficit by cutting/deferring expenditure. Its 1Q15 T-Bill borrowing calendar is actually quite reasonable with anet maturity of Rs 46bn.


Finally, lower rates would revive growth, improve tax buoyancy and improve the fiscal position a la FY04-08. In this connection, we agree with MoF chief economic adviser Arvind Subramanian " revive growth going forward, public investment may have to play a greater role to complement and crowd in private investment..." 


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