India Insight:RBI keeps rates on hold, as expected

Event

Repo rate kept unchanged at 7.25%, in line with our expectations: TheReserve Bank of India (RBI) has kept the repo rate (the rate at which RBIinjects liquidity) unchanged at 7.25%. The CRR was kept unchanged at 4%.

Accordingly, the reverse repo and marginal standing facility (MSF) rates standunchanged at 6.25% and 8.25%, respectively. This was in line with our andmarket expectations. RBI mentioned that ‘significant uncertainty will beresolved in the coming months, including the likely persistence of recentinflationary pressures, the full monsoon outturn, as well as possible FederalReserve actions. As the Reserve Bank awaits greater transmission of itsfront-loaded past actions, it will monitor developments for emergingroom for more accommodation’.

Policy implications: We maintain our base case expectation that there isscope for a further 25bp cut in policy rates in FY16, preferably during theperiod of Dec-15 to Mar-16 once the Fed’s normalisation of interest rates isbehind us (our US economist is building in a higher probability of the Fedlifting rates in Sept-15). We believe that real rates (as measured by CPIinflation) are still quite high. While positive real rates are necessary to providea reasonable return to savers, keeping them too high will adversely impactgrowth that has just started to recover.

What is the RBI saying and our views?

New monetary policy committee (MPC): In the media briefing post policyannouncements, the RBI governor Raghuram Rajan clarified that the RBI andthe government have reached a broad consensus on the setting up of MPC. Itwill be different from that proposed under the draft of Indian Financial Code(IFC) link. While the full details of the revised MPC will only be disclosed in theParliament, it seems that the RBI governor is not opposed to veto powerbeing taken away but rather mentioned that a committee-based structureensures greater continuity in policy and also helps mitigate pressure that mayfall on a single person responsible for policy setting. We believe the entireprocess will take another 6-9 months to get completed as this involvesamending the RBI act and will also need Parliamentary approval and wouldnot have much impact on the interest rate cycle in FY16.

Inflation to head lower before rising: RBI expects that a large base effectwill pull down headline inflation (CPI) in July and August. However, it will startrising again from Sept-15 as favourable base effects wane. RBI has retainedits target of 6% CPI inflation for Jan-16 but expects inflation for Jan-Mar2016 to be lower by 0.2% on softer crude oil prices and a near-normalmonsoon so far. This compares with our year-end CPI inflation forecast of5.6%. RBI believes that the full effect of the service tax increase, which tookeffect from June, will feed through over the rest of the year. Also they need tomonitor the price pressures seen in some food items particularly pulses andoilseeds as they tend to be sticky and impart an upward bias to inflation andinflation expectations. That said, the government’s proactive supplymanagement to contain shocks to food prices, especially vegetables, amoderate increase in minimum support prices and increase in planting ofpulses and oilseeds could have a significant mitigating influence.

The RBI has retained its 7.6% GDP growth forecast for FY16 but mentioned that outlook forgrowth is improving gradually: The GDP growth forecast is exactly in line with our expectations.

RBI mentioned that favourable real income effects could accrue from weaker commodity prices, inparticular crude oil, and a possible step-up in agricultural activity if monsoon conditions continue toimprove. On the other hand, weak global growth means the export contraction could become aprolonged drag to growth. Notwithstanding some improvement in the state of stalled projects,supply constraints continue to be binding and new investment demand emanating from the privatesector and the central government remains subdued.

Monetary policy transmission to happen with a lag: RBI mentioned that banks have loweredthe median base lending rates by only ~30 bps, a fraction of the 75 bps rate cut that has beenannounced till date. However, it believes that as loan demand picks up over the coming quarters,banks will see more gains from cutting rates to secure new lending, and more transmission willtake place. RBI mentioned that the recent announcement by government to infuse bank capitalinto PSU banks will help loan growth and hence transmission, as will currently easy liquidityconditions.