Yield rise will be capped as the RBI is likely to conduct more OMOs in the months to come which would support the markets<
20-Jun-12   10:57 Hrs IST

Mr.Arvind Chari
1) RBI in its mid-quarter monetary policy review has kept the repo rate and cash reserve ratio (CRR) unchanged, what are your reactions towards it?

In a 'surprising' move for the markets, the RBI held its rates steady. There was no change in any of its benchmark policy rates and liquidity measures. The Repo rate remains at 8.0% and the CRR at 4.75%.

The markets were clearly disappointed as most investors had priced in at least a 25 cut in the repo rate; with some hoping for a 50 bps cut. There were also expectations being built on a 50 bps CRR cut.

The absence of either has meant that bond yields have risen by 10 bps almost across the curve; Near term swap rates are up by 25 bps and equities are down about 1.5% with the bank index down more than 3%. Clearly a result of extended expectations.

 Although, our base case was of no change in rates, we had still assigned a small probability of a 25 bps rate cut largely on growth concerns and on the political pressure on the RBI to cut rates. But its good to see that the RBI has not yielded to political pressures and has rightly held out on its own.

  • The RBI had frontloaded its possible rate cuts given the macro economic scenario by cutting the repo by 50 bps in its April policy.
  • CPI and food inflation has gone up again and hence at the onset of monsoon, it was prudent to see how the monsoon pans out before taking a rate decision. Food inflation remains sticky and though core inflation is well below 5%, the RBI could not have overlooked the emerging threat of food inflation feeding through to generalized inflation
  • The rupee depreciation has also almost nullified the fall in global commodity prices. So although, we do not see any evidence of imported inflation, as despite the depreciation, commodity prices are lower in rupee terms from its peak in February, but there would be no major reduction in inflation from the fall in global commodity prices
  • Rupee depreciation is akin to rate cuts in terms of easing of monetary conditions through increasing competitiveness. Our belief has been that we should expect rate cuts only on some rupee appreciation. We expect to see significant demand stimulus from exports on the back of rupee depreciation in the months to come. This should narrow the current account deficit and lead to some sustained rupee appreciation over time.
  • Rate cuts would only offer temporary sentiment boost - the absence of it has been seen in the fall in asset prices - equities, bonds and currency - But rate cuts would not have helped industrial recovery. In RBI's own admission Estimates suggest that real effective bank lending interest rates, though positive, remain comparatively lower than the levels seen during the high growth phase of 2003-08. Thus, factors other than interest rates are contributing more significantly to the growth slowdown. Government decision making is far more crucial for boosting industrial recovery than interest rate cuts.
  • Also credit / deposit ratios remain high despite the apparent slowdown and deposit growth lags credit growth leaving little scope for lending rate cuts even on a repo rate cut. The requirement thus is of ensuring adequate liquidity than of rate cuts
  • We believe that RBI would pro-actively manage liquidity through need based OMOs (Open market operations)
  • They have, we believe wisely, kept the gun powder dry for future rate actions - on a greek exit or on further signs of slowdown - through rate cuts and CRR. We would still believe that repo rate can be cut by another 50 bps if monsoon pans out well; food inflation falls and the rupee appreciate. But RBI will hold its CRR arsenal for a 'Grexit'. RBI can potentially infuse about US $40 bln with 3% cut in CRR. (a likely estimate of fx outflows on a greek led contagion).

Although, the market seems disappointed but we think the RBI decision was the right one given the current scenario despite the slowdown in growth. It is important to send out a message to the politicians to get their act together in boosting investment activity and more importantly investment sentiment. In that regard, the potential change in the finance ministry should be regarded as positive for the markets and the economy.

Market impact

Given that the markets entered the policy with lot of expectations, we believe that the market sell off being witnessed is on expected lines. In bond markets, we believe though that the yield rise will be capped as the RBI is likely to conduct more OMOs in the months to come which would support the markets. The currency though needs some significant capital inflows to prop it up, which can come about only on positive investment sentiment being built up in domestic and global markets.

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