Saturday, June 9, 2012

>REPO RATE: Expect a 25bp repo rate cut on 18 June 2012

We now expect a 25bp repo rate cut on 18 June due to (a) weaker-than-expected real GDP growth of 5.3% y-o-y in Q1 2012, belying our and the Reserve Bank of India's (RBI) view that growth had bottomed in Q4; (b) despite rising headline WPI inflation, core WPI (non-food manufactured) inflation has continued to moderate, which suggests that pricing power has declined (India: Pricing power continues to fall, 15 May 2012); we expect a further moderation in core inflation in May (data due on 14 June); and (c) Brent oil prices have fallen to around USD100/bbl, more than offsetting the drag from INR depreciation. We assign a 20% probability to a 50bp rate cut at the June meeting. While sluggish growth, low core inflation and weak policy rate transmission argue for a more aggressive 50bp rate cut, our base case is a 25bp rate cut due to elevated headline inflation (primarily due to persistently high food inflation).

We do not expect a cash reserve ratio (CRR) cut on 18 June as liquidity is closer to the RBI's comfort zone and open market operations can be used to address the liquidity mismatch. Moreover, the CRR at 4.75% is close to the all-time low of 4.50% and needs to be kept ready as an emergency buffer to inject liquidity if conditions worsen.

We see upside risks to headline inflation in the coming months. However, the continued moderation in core inflation along with another weak GDP print in Q2 2012 (due 31 August) will likely prompt the RBI to accord a higher priority to growth. As such, following the expected 25bp repo rate cut at the June meeting, we anticipate another 25bp cut in H2.

In our view, interest rate cuts are only a quick fix to growth. The current slowdown in growth is largely a payback from continued fiscal excesses and reflects slow government decision-making over the past year (See: India: Make or break, 2 May 2012). Real effective exchange rate depreciation has already started to ease monetary conditions. As such, the current Indian stagflationary environment needs tight fiscal policy to create a more stable macro backdrop. We see two issues with cutting interest rates. First, in the current tight liquidity environment, the transmission of policy rate cuts may be delayed and sub-optimal. Second, and more importantly, when inflationary expectations are in double-digits and potential growth is at risk of falling below 7%, it will not take much for inflationary pressure to rear its head. Without concomitant fiscal tightening, loose monetary policy will likely fan inflation and lead to greater macroeconomic instability down the road.

To read  report in detail: RATE CUTS