We see Reserve Bank of India (RBI) Governor Raghuram Rajan cutting a final 25 basis points on February 2 after he expectedly paused on Tuesday. The RBI committed that it “…will use the space for further accommodation, when available, while keeping the economy anchored to the projected disinflation path that should take inflation down to 5 per cent by March 2017...” In our view, the focus will actually have to shift to liquidity with reserve money, at 11.2 per cent FYTD, running well below its long-run 14 per cent average.
We see three reasons for a February rate cut. First, CPI inflation is set to achieve the RBI’s ‘under-‘6 per cent January 2016 mandate. At the same time, the headroom for rate cuts is narrowing with the RBI repo rate, at 6.75 per ccnt, already below the 7 per cent medium-term average CPI inflation.
Secondly, growth is continuing to languish at 5.2 per cent (7.4 per cent in the new GDP series) in the September quarter well below our estimated potential of 7-7.5 per cent. This will naturally keep inflation in check. Finally, high risk free rates — the 10y is back at 7.75 per cent — will prevent lending rates from coming off as banks are unlikely to cut risk premium when there is a question mark on asset quality.
Against this backdrop, we continue to expect the RBI to OMO $8-10bn if FPI equity inflows do not revive. It has so far supplied only $3.5bn of the $30bn of permanent liquidity that we estimate is needed for FY16. In our view, FPI equity inflows are unlikely to revive till markets price in (1) the first Fed fund rate hike that we expect in December as well as (2) a turnaround in corporate earnings at home that we also see in December.
Finally, the RBI should steer the INR back to Rs.65/dollar levels after trade seasonality turns in its favor in the March quarter. The hike in FPI G-sec limits should also attract further inflows. Mr. Rajan has indicated that the fair value is around Rs.62-64/dollar. At the same time, the RBI will not want to fritter away precious FX reserves to fight a stronger U.S. dollar.
Indranil Sen Gupta is India Economist at Bank of America Merrill Lynch. Views are personal.
