RBI: Rate cuts not a given

After the Reserve Bank of India’s (RBI’s) surprise rate cut in March, markets have priced in further easing. This is not a given. Low inflation has given the central bank leeway to cut its key interest rate by 50 basis points so far this year, but the window is narrowing rapidly. A basis point is one-hundredth of a percentage point.

There are two reasons for this. Firstly, inflation may not continue to slow, owing to the rebound in crude oil prices and poor weather that has hurt winter crops. RBI itself expects retail inflation to stabilize in the second half of the year. Given the expected shift to a formal inflation-targeting regime and a lower inflationary path, the central bank will be data-dependent and proceed cautiously.

Secondly, as prospects for US rate hikes fade in and out, RBI will prefer front-loading cuts to the first half of 2015. Contrary to popular narrative, the Indian central bank is unlikely to lower rates in the face of US rate hikes. A case can nonetheless be made that India’s improved macro fundamentals reduce the need to tighten in response to higher US rates. On the policy outlook, the March rate cut leaves April’s review as a non-event. We expect another 25 basis point cut by June and for RBI to pause thereafter.

Beyond mainstream policy, another aspect that might garner interest is the currency direction. Given India’s track record, a strong rupee is a good problem to have, but not in this global environment. With inflation-targeting being the main policy focus, this approach implicitly carries a preference for stable-to-slightly-firmer rupee. This belief is also reflected in one of the RBI governor’s past writings, where when faced with a choice between controlling higher domestic inflation or a more competitive currency, the preference will be to curb inflation.

A currency positioned to lower inflation is, however, at odds with the economy’s broader push to promote export-oriented manufacturing through the “Make in India” initiative. Among other things, such a policy requires a competitive exchange rate. This path was pursued by China and other export-oriented economies in the initial phase of their development cycle.

The rupee’s recent moves are, therefore, a concern. The currency has risen by 13% against its trading partners in inflation-adjusted terms since January 2014. Rather than being led by a boost in domestic productivity, the rupee gains are a result of accommodative global policies which have depressed international currencies. With global central banks likely to keep their feet on the stimulus pedal, the Indian unit will stay firm on a comparative basis.

In our view, this conundrum is likely to influence RBI’s intervention strategy. Low commodity prices have kept a lid on imported inflationary pressures, providing some leeway on the currency front. Bias, therefore, will be to provide a strong floor for the dollar/rupee, with risks skewed towards the upside. This was also evident in RBI’s dollar purchases in January, the highest in seven years. In fact, the central bank has been a net buyer of dollars in 10 of the past 13 months, in both spot and forward markets. The pair’s upside bias will also lend a hand to the flagging external sector and encourage hedging activity among corporates/importers to shield their balance sheets.

To retain trade competitiveness, the authorities are likely to stay in sync with other regional currencies. The broad dollar strengthening (spurred by expectations of rate cuts by the US Federal Reserve and quantitative easing in Europe and Japan) will see RBI tolerate measured rupee weakness. More importantly, a gradual adjustment process is likely compared with the volatility experienced during the “taper tantrum” in 2013.

Radhika Rao is economist and vice-president at DBS Bank Ltd.

This is the first in a series of three articles by economists ahead of the Reserve Bank of India’s bimonthly monetary policy review on 7 April.