RBI cuts welcome: Indranil Sen Gupta

We welcome Reserve Bank of India(RBI) Governor Raghuram Rajan's decision to cut rates by 25bp this morning. This is in line with our long standing call for a 25bp rate cut in February and an overall 75bp cut in 2015.

It is more than evident that the January consumer price index (CPI) inflation, that we are tracking at 6.1 per cent, will meet the RBI's eight per cent forecast, with commodity prices coming off on Federal Reserve rate hike expectations, as well as rupee stabilising with the central bank recouping FX reserves.

We also remain confident that CPI inflation will meet the RBI's six per cent January 2016 target. On our part, we expect banks to cut lending rates 50-75bp after the slack season sets in April. This should transmit to growth in six months by October. This, in turn, supports our view of a slow recovery in growth to 6.3 per cent in FY16 from 5.5 per cent in FY15.

The rupee has reacted positively to RBI's rate cut decision and this also is very much in line with our expectations, that the rupee should appreciate when RBI cuts rates because the Foreign Institutional Investor (FII) equity portfolio, at about $330bn, which responds to growth, is six times the FII debt portfolio, which may respond to higher rates. On our part, we expect RBI to hold Rs 60-65 per dollar in 2015 on dollar strength. The next cut is now expected in April, after greater clarity on oil prices.

The question has naturally shifted from "...when will the RBI cut..." to "...how much will it cut..." While we were ahead of the street in our February RBI rate cut call, we also point to three reasons to expect a relatively shallow RBI rate cut cycle relative to 2003 or 2008-09. First, RBI now 'targets' CPI inflation rather than the wholesale price index (WPI).

The threshold growth-maximizing CPI inflation works out to 6.2-6.7 per cent (according to the Patel report) much higher than the 4.6-5.5 per cent for WPI. Second, the Fed is likely to hike rates from September. In the past, the Fed and the RBI cut/hiked together. Finally, the interest differential between the RBI's and the Fed's policy rates will be higher as lower import cover raises risk premia for the rupee.

Indranil Sen Gupta
India Economist, Bank of America-Merrill Lynch