We expect Reserve Bank of India (RBI) governor Raghuram Rajan to pause on 4 August on the back of a poor monsoon and the first interest rate hike by the US Federal Reserve that we see in September. At the same time, he will likely strike a dovish note to keep the door open for further rate cuts if inflation remains under control—as indeed we think it will. With rains over and US Fed action priced in, RBI should cut another 50 basis points in early 2016 to support growth atop the 75 basis points it already has.

We worry that southern and western India may slip into drought, although rains are still running at 95% of normal overall. This region grows oilseeds, pulses and raw cotton, whose prices can shoot up pretty quickly. Against this backdrop, the delay in rains poses a temporary inflation risk. A 5% increase in agflation will drive up inflation based on the Consumer Price Index (CPI) by 250 basis points and inflation based on the Wholsesale Price Index (WPI) by 175 basis points. At the same time, we think CPI inflation will fundamentally remain on course to RBI’s under-6% CPI inflation target, with the Fed tightening expectations keeping global commodity prices in check. Daily agricultural prices data suggests downside risks to our 4.3% July CPI inflation forecast.

A disappointing monsoon is indeed a misfortune as the stars seem to be otherwise aligning for further RBI rate cuts to support recovery. First, the government’s limited increases in minimum support prices restrain agflation. Second, oil prices are likely to settle down at $55 a barrel, with the Iran deal going through. This should contain imported inflation. Finally, Grexit is no longer a worry for now.

That said, we do not expect the Narendra Modi government to use RBI to fight agflation, beyond a pause, from a rain shock. It will likely respond with supply-side measures like the previous National Democratic Alliance government did during the 2002 drought. In fact, former RBI governor Bimal Jalan cut cash reserve ratio and interest rates at that time to pave the way for the India growth story. Retailer margins (i.e., the difference between CPI and WPI agro prices) have come off in the past one year, testifying to better supply management.

We will look to the Federal Open Market Committee statement of 29 July for cues for the first Fed hike that we expect in September. There, however, is a strong possibility the Fed may remain non-committal, in line with its data-dependent monetary policy stance. In such a case, the market reaction will become critical for RBI’s own 4 August rate decision. Markets are currently pricing in a 40% chance of a September Fed hike. If the market sees the Fed as hawkish, RBI will have one more reason to pause on Tuesday. If it is dovish, there is a possibility that it may hike foreign portfolio investors’ government securities limit by about $5 billion.

We continue to expect governor Rajan—like governors Jalan and Y.V. Reddy before him—to recoup forex reserves to fight off contagion. After all, import cover stands at about nine months on March 2016 basis, which is not much higher than the eight months that is critical for rupee stability. Governor Rajan has reiterated that the rupee is close to fair value at current levels. We continue to expect RBI to buy at 60-62 a dollar, offer token resistance at 63-64 and sell, say, $15 billion to defend 65. It is true that there could be a knee-jerk sell-off of emerging markets before the first Fed hike. At the same time, we do not see a threat to the rupee relative value trade given the credibility that governor Rajan has built up by aggressively buying forex.

We think that further scope for RBI open market operations sales is limited unless portfolio inflows revive substantially. Although money market liquidity is seasonally easy, reserve money growth has skidded to 10% levels from a medium-term average of 14.3%. Not surprisingly, loan growth has also slipped below 10% from a medium-term average of 21%, limiting transmission of RBI rate cuts to lending rate cuts. While RBI has contracted forex forwards of some $27.8 billion with banks, it will not really be able to accept them as banks need day-to-day working nostro balance of $10-15 billion and RBI itself will have to provision for withdrawal of, say, $15 billion when the 2013 FCNR (foreign currency non-resident) deposit-cum-concessional swap scheme matures in end-2016.

This is second in a series of three articles ahead of RBI’s monetary policy review on 4 August.

Close