RBI’s commentary more critical than a token cut of 25bps: India Ratings

This is because global headwinds can test the resilience of the rupee in the short term. We thus believe that the RBI will be less inclined towards suggesting aggressive accommodation.

India Ratings and Research (Ind-Ra) expects the Reserve Bank of India (RBI) to take a gradual route of repo rate moderation (by 25bp to 7%) and sound cautious in its tone. This is because global headwinds can test the resilience of the rupee in the short term. We thus believe that the RBI will be less inclined towards suggesting aggressive accommodation. Nonetheless, any affirmative announcement on the medium-term framework for foreign portfolio investment limits in debt securities might spell cheer.
 
All Measures of Inflation Down Sharply: In Ind-Ra’s view, a sharp decline in inflation particularly the GDP deflator should pave way for the repo rate cut. Retail inflation was down sharply to below 3.7% (core inflation 4.1%) in August from 5.4% (4.8% core) at the time of RBI’s previous policy announcement. Wholesale prices have been falling in absolute terms and GDP deflator is negligible (GDP deflator is at its lowest in 16 years). Capacity utilisation for corporates is at a decade low according to a study by Ind-Ra (refer: Study of Capex Cycle of Top 500 Indian Corporates) and the slack should keep core inflation low. Commodity prices should also remain subdued given concerns on the global growth outlook and finally as exports continue to shrink, the onus of growth recovery remains with government spending and consumption.
 
Bracing for US Rate Hike in 2015: We noted in the last edition of DebtFx that uncertainty will likely prevail in global markets on the delayed normalisation of rates in the US. We also opined that US dollar (USD) might be stronger than the majors and emerging market currencies in the medium-term. This has happened, but clearly earlier than we expected. "Cyclical" factors, notably rising US interest rate expectations, are once again supporting the USD. US Fed Chair Janet Yellen recently indicated that the central bank is poised for rate normalisation in 2015 just a week after keeping rates steady, citing global concerns. A slowing China, soft commodity prices and worsening financial market conditions also pose a risk to the growth outlook for several countries which have strong trade linkages with China. Widening credit default spreads for some of these countries suggest “Structural” concerns as well. Emerging market currencies and equity price movements are thus clearly reflecting risk aversion.
 
Tactical Caution on Rupee: Ind-Ra believes RBI will have limited headroom for a significant rate reduction in the coming policy. Near-term outlook on the rupee might be clouded by a perception of risk. Hence, capital flows may flicker in response to the degree of global developments which could keep market edgy. While the broader theme of relative resilience of the rupee is intact, and the performance of the rupee relative to that of other currencies (down only 4.9% year to date, versus sharper cuts elsewhere in the EM space) is an indication of that, there still remains a case for rupee weakness on an absolute basis in such an environment.
 
Gilts Supported Ahead of Policy: Ind-Ra believes a potential rate cut by RBI as also the likelihood of an announcement of a Foreign Portfolio Investment gilt limit hike (current: USD30bn) should keep gilts supported ahead of policy. Crucially, investors’ expectations of a further policy room for accommodation will be shaped by RBI’s assessment and further guidance, if any. Domestic government bonds have stayed in a broad consolidation phase over the past week, despite choppy currency movements.