by NR INDRAN / INT

The Reserve Bank of India (RBI) hiked the repo rate by 25 bp, in line with the Bloomberg consensus and our expectations. After today’s decision, the repo rate moves up to 8.50%, while the reverse repo rate and the marginal standing facility rate move automatically to 7.50% and 9.50% respectively. The cash reserve ratio (CRR) remains at 6.00%.The central bank also deregulated the bank savings deposit rate.

While the rate hike was expected, the accompanying statement was fairly dovish. The RBI has revised its GDP growth forecast down to 7.6% from 8% for FY12. It also highlighted growing risks to growth from global factors and slowing domestic investment demand. Our FY12 GDP growth forecast remains at 7% with downside risks and we think the RBI may need to still revise its growth forecasts downwards.

While high headline yoy inflation numbers led to the hike, the RBI recognized the sequential slowdown in inflation.  It stated that “there is some comfort coming from de-seasonalized sequential quarterly WPI data which suggest that inflation momentum has turned down”, something we have been flagging for sometime now. Sequentially, WPI inflation continues to fall, and stands at 6.4% qoq s.a. annualized in September, while core has fallen to 4.8% qoq s.a. annualized. The RBI’s end-March WPI inflation forecast remains at 7%, while we think it could be lower at 6%.

The central bank also deregulated the savings bank deposit rate. We think this is a positive move for the economy, even though it is a negative for banks as it will increase their funding costs. The measure will increase competition and can enhance efficiency in the banking system, along with increasing real deposit rates for savers, who were suffering from negative real rates.

The RBI has signaled not just a pause but a stop to rate hikes, as we expected. It said that “the likelihood of a rate action in the December mid-quarter review is relatively low. Beyond that, if the inflation trajectory conforms to projections, further rate hikes may not be warranted”. With this statement, we think the data on inflation would have to surprise significantly to the upside for the RBI to change its stance. The RBI could have chosen the option to not be so explicit about a stop to rate hikes, but by so doing, we think it has enhanced its credibility, and dispelled uncertainty about rates and anchored future expectations. We continue to think that with inflation and growth likely to surprise on the downside, the RBI will likely cut interest rates in April 2012, and we have built in 100 bp in rate cuts in FY13.

The RBI’s statement on exchange rate policy suggests to us that it may continue to intervene to prevent further depreciation. The RBI reiterated its commitment to “retain the flexibility to intervene in the market to manage excessive volatility and disruptions to macroeconomic stability”. The positive intent in this statement as opposed to the generic previous statements that the RBI does not intervene in currency markets except to dampen volatility, is significant in our view, especially in light of the recent interventions by the RBI.

On liquidity, the RBI expressed satisfaction with the level of systemic deficit. This suggests to us that the RBI is still not ready to inject liquidity through open market operations or a CRR cut. We think that this could happen in January-March 2012 as headline inflation numbers recede further. Therefore, with the government’s large borrowing program, we think there could be upward pressure on government bond yields.

The focus will now shift to fiscal policy. We think that looser-than-expected fiscal policy and tighter-than-expected monetary policy is complicating the policy mix. We have recently revised up our central government fiscal deficit target to 5.8% of GDP for FY12, as revenues are slowing due to a waning of the growth momentum (see India: A worsening of the fiscal-monetary policy mix, Asia Economics Analyst 11/18, October 20, 2011). The worsening policy mix can put upward pressure on government bond yields, and can be a negative for the INR. Now that monetary policy is on hold, the focus will shift to fiscal policy to rein in the government’s borrowing needs.

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