As expected, the RBI left key policy rates unchanged in the mid-quarter review today. The increased emphasis on inflation has come as a surprise to the markets. On balance, we think the RBI will still prefer to cut rates in April 2012 although its ability to cut rates aggressively in FY13 will remain limited.

RBI Leaves Key Rates Unchanged

RBI left the key rates – Repo and CRR – unchanged, as expected, in today’s monetary review. While we did not expect the RBI to give a clear indication of when it would be comfortable embarking on Repo rate cuts, the statement today gives the market little reason to believe that Repo rate cuts can be taken as a given in April 2012. This is so for a number of reasons.

Is The Rate Cut In April 2012 A Given?

In the last policy in January 2012, there was a clear shift in the RBI’s priority towards growth. The RBI had highlighted that “the growth-inflation balance of the monetary policy stance has now shifted to growth.” But at the same time, it did not seem exceedingly worried about growth as it looked for a modest recovery, from these levels, in FY13. In the review today, RBI seems to have upped its concerns on inflation yet again, highlighting new problem variables, such as rising current account deficit, recent surge in crude oil prices, price pressures persisting at the retail level, while reiterating the urgent need for fiscal consolidation, highlighted earlier. So in that sense, RBI has re-emphasised the importance of monetary and fiscal policy co-ordination to give the much-needed fillip to growth, rather than taking the sole responsibility of addressing growth concerns. As far as the other variables, such as current account deficit and crude prices are concerned, there may be no resolution to the former in the near-term, given the surge in latter. This reiterates our call that RBI will be unable to cut rates 1) aggressively 2) very decisively in FY13.

Politics Versus Economics

To the extent fiscal consolidation is important, we think the economics of it should  be favourable in the budget to be presented tomorrow. Even if there’s credible consolidation of 0.5-1 per cent of GDP, implying the fiscal deficit to GDP ratio of 4.8-5.3 per cent, we think the job will be done. But the politics that follows post the budget, the preview of which was visible post the railway budget yesterday (with TMC demanding resignation of the railways minister following the proposed passenger fare hikes) will be critical. Thus, the budget tomorrow and the events that follow will be reasonably important from the RBI’s rate cut point of view.

On balance, we think April rate cut is likely. Considering that any slippage on the fiscal front will not be visible overnight but over the course of the year, RBI will have to base its rate cut call on what’s being offered in the budget tomorrow, qualitatively and quantitatively. Given our base case of fiscal consolidation of 0.6 per cent of GDP in FY13 and the need to support growth and investment, we think the RBI will choose to cut rates in April 2012. Trajectory and quantum of inflation will be important. We do not anticipate any significant fall in inflation below 6.5 per cent YoY in FY13, given the pressures both from fuel and food. While a spike in WPI inflation is likely as and when the domestic oil prices see partial hikes, we think the RBI would differentiate between one-off administrative corrections in inflation with longer-term pressures, justifying a rate cut in April. We stick with our call of average WPI inflation at 7.2 per cent YoY in FY13. Unless growth slips significantly, which is not our base case; this will rather restrict the RBI’s ability to cut policy rates in FY13. We expect a cumulative of 125 bps cut in the Repo rate in FY13.

To the extent RBI needs to support the faltering growth, partly this has been done by provision of liquidity (Rs 800 billion) via CRR cuts. But any significant change in lending rates by banks is unlikely to materialise unless there’s a clear signal on Repo rate. 

(Deepali Bhargava is chief economist, India, for Espirito Santo Securities, formerly Execution Noble).

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