by NR INDRAN

Mr. Tushar Poddar, Chief Economist, Goldman Sachs India.

The Reserve Bank of India (RBI) hiked the repo rate by 50 bp, ahead of the Bloomberg consensus and our expectations of a 25-bp hike. The extent of the surprise can be ascertained by the fact that 20 out of 22 analysts on Bloomberg expected a 25-bp move and the rest expected no change. After today’s decision, the repo rate moves up to 8.00%, while the reverse repo rate and the marginal standing facility rate move automatically to 7.00% and 9.00% respectively. The cash reserve ratio (CRR) remains at 6.00%.

We think that there is a high probability that the RBI is done with rate hikes:

First, the move was motivated by a desire to firmly get ahead of expectations and front-load the tightening. With this move, the RBI has significantly surprised the market with the rapidity and extent of its rate hikes. We were expecting another 50 bp in total this year, ahead of market expectations of 25 bp for the remainder of 2011. Having burnished its anti-inflation stance, we believe there is little need for the RBI to hike further to enhance its commitment to fighting inflation and keeping medium-term expectations anchored.

Second, by raising its inflation forecasts and its anti-inflation rhetoric, the RBI has opened the possibility of downside surprises, whereas earlier it was playing catch-up with upward surprises to inflation.

Third, given the headwinds to global growth and the ongoing and impending slowdown in domestic growth, we think that growth may surprise significantly to the downside of the RBI’s target.

Fourth, we do not see further increases in crude prices or food prices, and thereby upside surprises to inflation.  We see inflation peaking by August/September and then trending down.

We therefore see a very high bar for the RBI to hike further on September 16, unless there is a significant upside surprise to inflation.  Although the rhetoric in the policy statement was hawkish, given the extent of the rate hike, we think the RBI was unlikely to dilute the impact of its move by signaling a pause at this stage.  If rate hikes are done, then this would lead to a gradual bottoming out of the investment cycle, which we expect to happen by end-FY12, and a recovery thereafter (see India: Timing the bottom of the investment cycle, Asia Economics Analyst 11/12, July 7, 2011). We believe the move is bullish for the INR due to higher carry; and for paid positions at the long end of the swap curve.

The RBI made its future rate action dependent on the trajectory of inflation. It said ‘change in policy stance to be driven by signs of a sustainable downturn in inflation’. The RBI noted that it had to take stronger action in the absence of supply-side responses and deterioration in the fiscal balance. The RBI listed the factors that would determine the inflation outlook—the performance of the monsoons, the outlook for crude prices, and policy decisions regarding administered fuel prices. Our view remains that of a normal monsoon, not much upside to crude, and no further increases in locally-administered prices. Therefore, the policy statement does not fundamentally change our inflation outlook.

The RBI raised its inflation forecast for March 2012 to 7% from 6%. The revision came on the back of higher non-food manufacturing inflation, the recent increase in domestic administered fuel prices, and increases to the minimum support prices of certain food items. According to the central bank, inflation remains the dominant macroeconomic concern and it reiterated that inflation is expected to remain elevated for a few more months before moderating towards the later part of the year.

The RBI kept its growth forecast unchanged at 8% for FY12. The central bank said that though there were signs of growth moderation in some sectors, however there was no evidence of a sharp or broad-based slowdown yet. According to the RBI, several activity indicators like merchandise trade, indirect tax collections, corporate sales and earnings, bank credit growth still suggest that demand is moderating only gradually. We think that GDP growth will slow more than the RBI’s target, and our forecast is 7.5% for FY12.

While credit growth has moderated, the central bank further reduced its credit growth targets.  Non-food credit growth was revised to 18% yoy from 19% yoy for FY12. The central bank also revised its M3 growth forecast downward by 50 bp to 15.5% yoy. However, it expressed its satisfaction over the monetary transmission which is evident by the 225 bp in hikes in both the deposit and lending rates by the scheduled commercial banks since March 2010.

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