Mumbai: The rate-setting waters have potentially been muddied by the weak May industrial production release, and by the first drop in the WPI rate for two months
Judging by the initial reaction of equities, the market is confident that the withdrawal of the Left Parties from their support of the government and the formation of a new coalition will lead to significant structural reform prior to the general election, which must be held by May 2009.
Also, Finance Minister Chidambaram encouraged such speculation by suggesting that pending legislation, removing the 10% limit on the voting rights of foreigners in private banks may be revived, while the ceiling on FDI in insurance companies could be lifted from 26% to 49% and the pensions industry will also open up to foreign competition.
The nuclear deal with the US, over which the trust vote was triggered, will presumably also be delivered.
All this begs the question, however, that if there was always an alternative, pro-reform coalition arrangement waiting in the wings, why didn’t the government establish it at the beginning of its term, rather than the end?
Perhaps, because it will prove problematic to keep together, while the government’s new supporters will presumably demand measures in return for their loyalty. The latter are likely to involve populist steps that will put further upward pressure on the budget deficit.
As for next week’s RBI meeting, the rate-setting waters have potentially been muddied by the weak May industrial production release, and by the first drop in the WPI rate for two months (in the week ended 12 July).
In practice, however, we wouldn’t have thought either development should hold much sway. Our analysis, suggests that the Central Bank pays little attention to industrial developments when determining rates. Indeed, the correlation between production growth and the repo rate has been -0.5 since 2001.
As for inflation, it seems a little premature to call the peak on the basis of a fall from 11.91% to 11.89% in the headline WPI, particularly when base effects will shortly turn negative again (WPI inflation fell from 4.7% to 3.1% between July and October last year) and the uneven monsoon season threatens higher food prices.
The policy rate remains negative in real terms, credit growth has picked up and M3 growth, although weaker, is still comfortably above target.
While acknowledging the RBI often likes to surprise markets, we are sticking with our call of 25bp repo and CRR hikes at 29 July’s meeting and a total of 100bps of increases in both rates between now and the end of calendar 2008.