Photo: Bloomberg
Photo: Bloomberg

RBI may turn dovish in April, cut rates in June

The central bank should thereafter pause to see the expected September US Federal Reserve rate hike through

I expect Reserve Bank of India (RBI) governor Raghuram Rajan to turn more dovish on 7 April and cut rates next in June. RBI should thereafter pause to see our expected September US Federal Reserve rate hike through. I have pencilled in another 50 basis points (bps) of repo rate cuts in early FY 2016 after the financial markets have priced in the Fed action. (A basis point is one-hundredth of a percentage point.)

With inflation likely set on the “under-6%" January 2016 target, I continue to expect RBI on 7 April to edit the 4 March statement to commit “…further easing barring renewal of inflationary pressures or global volatility…" from “…further monetary actions will be conditioned by incoming data, especially on the easing of supply constraints, improved availability of key inputs such as power, land, minerals and infrastructure, continuing progress on high-quality fiscal consolidation, the pass through of past rate cuts into lending rates, the monsoon out-turn and developments in the international environment…"

I do not expect RBI to cut rates on 7 April. After all, the rationale for acting inter-meeting on 4 March was “…while the next bi-monthly policy statement will be issued on April 7, 2015 the still weak state of certain sectors of the economy as well as the global trend towards easing suggests that any policy action should be anticipatory once sufficient data support the policy stance…."

I see little reason to cut the cash reserve ratio (CRR) with credit demand set to weaken in the slack season. A 50 bps of CRR cut improves banks’ net interest margins by only 4-5 bps, allowing 10 bps of lending rate cuts on average.

I have been sceptical—correctly—of the repeated statutory liquidity ratio (SLR) cuts having any impact on lending rates at this stage of the economic cycle. Banks typically mark up their prime lending rates over the risk-free 10-year government securities yield by about 400 bps. In a downturn, an SLR cut actually prevents the 10-year bond from falling, as banks are unwilling to compress the risk premium when there is a question mark over the asset quality.

In any case, we expect banks to cut by 25 bps after the slack season sets in, in April. Banks should cut lending rates by 50 bps in April-September 2015. The need for softer lending rates will inevitably put the spotlight on RBI’s ability to step up reserve money expansion to boost loan supply. I estimate that 1 of reserve money generates 4 of loan supply. With reserve money growing only 12.6% year-on-year, as on 20 March, credit offtake is also stuck at a low 10.2%, as on 6 March. I estimate that reserve money expansion of $48.4 billion (15.5%) is needed to support loan demand of 17.5% in FY16.

I expect the (Narendra) Modi government to use supply-side measures rather than RBI tightening against any food price inflation from unseasonal rain. In any case, under the recent monetary policy agreement, the government provides nine-month flexibility to RBI to address any breach of the 2-6% consumer price inflation band, so that there is sufficient time for supply shocks to work themselves out.

RBI will likely continue to buy foreign exchange to guard against contagion from our expected September Fed rate hike. Our balance of payments estimates suggest that RBI can achieve 10-odd month of import cover—above the eight-month minimum—by March 2016 if oil persists at $55 per barrel.

I continue to see a possible three-step foreign exchange policy from RBI. It will buy forex at 60-62/dollar as it is doing. It will offer token defence at 63-64/dollar selling, say, $500 million-1 billion, as it did in December-January. I see full-scale forex intervention of, say, $15 billion, at 65/dollar.

I expect a hike in the G-sec limit for foreign institutional investors (FIIs) by $5 billion (inclusive of $1.5-2 billion from reinvestment of coupons) with Fed hikes some distance away. After all, FII debt inflows are inflating prices of quasi-G-secs as they can’t be invested in G-secs.

This is the last in a series of three articles by economists ahead of the Reserve Bank of India’s bi-monthly monetary policy review on 7 April. Views are personal.