Mumbai: The battering that sent the rupee to a record low last week was an important reason why the Reserve Bank of India (RBI) decided to hit the pause button on Monday, when it left its key lending rate unchanged. The decision by governor D. Subbarao came after three consecutive rate cuts since January to support a weak economy.
In a cautious monetary policy statement, the Indian central bank also indicated that the long battle against inflation has not yet drawn to a close, despite the sharp decline in wholesale price inflation in recent months.
“It is only a durable receding of inflation that will open up the space for monetary policy to continue to address risks to growth,” it said.
RBI also said its outlook on inflation “will be determined by suppressed inflation being released through revisions in administered prices, including the minimum support prices, as well as the recent depreciation of the rupee”.
Though RBI bank did not give any clear commitment on its future policy course, private sector economists indicated in various research notes released after the announcement of the monetary policy that they expected modest rate cuts in the coming months, perhaps as early as July, as long as the currency remains stable and a good monsoon helps ease food prices.
Even as the central bank said that “the most significant development in the external sector has been the movement in the exchange rate”, new data released by the government on Monday served as a useful reminder of the fragile balance of payments situation, the underlying cause for the weak rupee. India’s trade deficit in May widened to its highest level in seven months (see page 6).
The repo rate at which RBI lends short-term funds to banks has been retained at 7.25%. RBI left the cash reserve ratio (CRR), the portion of deposits banks need to park with the central bank, unchanged at 4%, saying that liquidity conditions have eased in the banking system.
The rupee had touched a lifetime low of 58.99 against the US dollar on 11 June, though it has recovered some lost ground since then. Since January, the Indian currency has lost 4.73% against the dollar and is the third worst performing currency among Asian currencies this year.
A record trade deficit combined with fears that the US Federal Reserve could begin to withdraw some of its monetary stimulus has rattled the rupee and other emerging market currencies.
The US central bank is to have a key policy meeting later this week.
Poor transmission of previous rate cuts in the banking system has made earlier rate cuts ineffective. Not many banks have cut their minimum lending rates in the last one year despite RBI slashing its effective policy rate in phases.
Reacting to the policy, finance minister P. Chidambaram said he recognized that RBI was independent while C. Rangarajan, chairman of the Prime Minister’s economic advisory council, said “external factors” will be predominant in RBI’s future decisions.
The financial markets, which had already factored in a decision to leave policy rates unchanged, reacted positively in the latter half of the day on optimism that RBI will cut rates later.
Government bonds rallied, with dealers attributing this to expectations that RBI will continue to buy bonds in the secondary market to bolster liquidity, through so-called open market operations (OMOs).
The yield on India’s 10-year bond fell eight basis points to 7.238% intra-day from 7.31% prior to the policy announcement. It ended the day at 7.255%. Bond prices and yields move in opposite directions.
“Since there was no CRR cut, markets feel that there will be more OMOs, which is positive for the bond market,” said Moses Harding, head of the asset liability committee and economic and market research at IndusInd Bank.
The stock market, which initially didn’t react to the policy announcement, later picked up positive cues.
India’s benchmark equity index, the S&P BSE Sensex, which was trading flat after the announcement, ended 0.77% higher at 19,325.87 points. The broader Nifty index closed the day 0.72% up at 5,850 points.
The rupee, which had fallen to 57.87 against the dollar after the RBI announcement, later pared most of its losses to rise to 57.55 intra-day; it closed at 57.87, down 0.58% from its previous close.
Industry associations were disappointed by the policy. “The decision of the RBI to hold policy rates is disappointing,” said Chandrajit Banerjee, director general of the Confederation of Indian Industry.
“At a time when both growth and inflation dynamics call for an accommodative monetary policy, the RBI has taken a cautious approach of attending to the prospect of a possible resurgence in inflation over reviving growth in the economy,” he said.
“Investment sentiment has to be supported constantly...if the lending rates are not brought down with immediate effect it would have a serious to moderate impact on (corporate) investment plans. As the monetary transmission mechanism has been weak, RBI will need to focus on the outcome of lower lending rates by banks,” said Naina Lal Kidwai, president of the Federation of Indian Chambers of Commerce and Industry.
Diwakar Gupta, managing director and chief financial officer of the country’s largest lender, State Bank of India, said he was not expecting a rate cut, but “was hoping for one”.
After hiking the repo rate 13 times between March 2010 and October 2011 to fight inflation, the Indian central bank began lowering rates in April last year with a sharp cut of 50 basis points. A basis point is one- hundredth of a percentage point.
Since March last year, RBI has also reduced CRR by 75 basis points, in phases.
Wholesale price inflation slowed to a 43-month low of 4.7% in May from 4.89% in April, on the back of declining prices of fuel and manufactured products. Retail inflation also dropped in May—to 9.31% from 9.39% in the previous month.
On the other hand, growth slowed to a decade-low of 5% in the last fiscal year.
Rate cut in July?
Despite the cautious tone of RBI, most economists expect the central bank to cut rates by 25-50 basis points in the remaining part of the fiscal year. But this will happen only if the rupee stablilizes and the monsoon turns out to be good one, they said.
The central bank remains concerned about inflation as much as growth, especially in the backdrop of the recent depreciation of the rupee, said Leif Lybecker Eskesen, chief economist for India and Asean, and Prithviraj Srinivas, economics associate at Hongkong and Shanghai Banking Corp. Ltd in a report.
“It will, therefore, likely remain in wait-and-see mode until it has more clarity about the direction of the current account and inflation, which partly depends on the currency and, therefore, global factors,” they said. “The room for rate cuts would also be determined by the extent to which the government continues its reform push.”
Roland Randall, senior economist at Australia and New Zealand Banking Group also said rate cuts will depend on the rupee’s course.
“The window for another RBI interest rate cut may open again this year. As long as INR (Indian rupee) does not experience further rapid depreciation, we expect RBI to cut 50 bps (basis points) before the end of September, with the first likely to come on 30 July,” Randall said.
Taimur Baig and Kaushik Das, economists at Deutsche Bank AG, said they expect RBI to cut rates in July, September and October by 25 basis points each.
“Since real interest rates have turned positive in WPI (Wholesale Price Index) terms and improved significantly even when measured in terms of CPI (Consumer Price Index) inflation, the case for further easing is amply clear,” the Deutsche Bank economists said.
Siddhartha Sanyal and Rahul Bajoria, economists at Barclays Plc, said any further weakening in the currency will make the central bank’s options for July more complicated.
“We feel the developments in the global economy and the trend in the INR in the next few weeks will have a strong bearing on the RBI’s action,” they said.
But they expect another 75 basis points cut in the remainder of the calendar year.
Besides domestic factors, economists said RBI will keenly look at the meeting of the Federal Open Market Committee on 18-19 June, which will give an indication of whether Fed will taper off its so-called quantitative easing programme by reducing bond purchases.
On the domestic front, a likely narrowing of the current account deficit will also prove decisive for RBI to ease its policy stance, they added.