RBI might hold rates for now

Hawkish policy stance could push Bank Nifty by 1,000 points down

The latest Index of Industrial Production (IIP) data and the inflation data present a puzzle for the Reserve Bank of India (RBI). First, the IIP year-on-year (y-o-y)change for April 2015 over April 2014 has been revised down from a strong 4.1 per cent to a mildly encouraging 3.4 per cent up. Second, the May 2015 IIP data reveals slowing trends in manufacturing, since the IIP is up only 2.1 per cent y-o-y. But it is worth noting the IIP has now been positive for five months in a row and that is encouraging.

The Wholesale Price Index (WPI) is in a strongly negative trend. It was down by minus 2.4 per cent y-o-y for June. That was the seventh month in a row where WPI stayed in negative territory. In contrast, the Consumer Price Index (CPI) rose 5.4 per cent y-o-y in June, moving up from a reading of 5.01 per cent in May.

The CPI uptick was driven by rising food prices, specifically a 22 per cent spike in pulse prices. It was an eight-month high on CPI. The differential between CPI and WPI is large and growing, even allowing for differences in the weights of the same items. This should be good for manufacturers, since CPI inflation remains moderate.

What does RBI do at its policy meet on August 4? Apart from concerns about domestic inflation and GDP growth, the central bank must also review falling exports in the past three quarters. The trade balance has actually improved due to the falling prices of crude and gas. But, in addition to lower exports, there could be another potential problem: external commercial borrowings have risen.

The low IIP is a strong argument is favour of cutting policy rates. There is another good argument - bank credit growth is also at multi-year lows. A rate cut (the third this calendar year) could stimulate the investment cycle.

By August 4, RBI will also have a fair take on first quarter (Q1) corporate trends. Assuming Q1 corporate growth stays muted, as everybody seems to expect, there could be another argument in favour of cutting rates.

In the past, when WPI was the major benchmark inflation indicator, there would have been no arguments. The central bank would have cut rates without much ado. However, the rising CPI and focus on consumer inflation present an argument against rate cuts.

Specifically, RBI's inflation target is to keep CPI inflation below six per cent by December 2015 (that data will be released in January 2016). Since CPI was at 119.4 points in December 2014, it should stay below 126.6 in December 2015. The June CPI value was 123, up from 121.6 in May. So there is some leeway, but not much. RBI may hold off on rate cuts. A counter-argument is that food inflation cannot be reduced much by monetary policy.

On the external front, it is difficult to judge the best course of action. Crude oil prices are low and promise to stay so for a while given slow global growth and the easing of sanctions on Iran. So, import pressure will not be high. On the other hand, exports are falling in all categories. Companies have reportedly been emboldened to borrow substantially abroad without hedging. One estimate is that only about 15 per cent of ECB are hedged. Borrowings in 2014-15 came to over $25 billion.

RBI might want to let the rupee move lower to encourage exports and discourage indiscriminate, unhedged ECBs. It may also choose to wait until the US Federal Reserve finally raises policy rates, either in September or December, before it takes a call on pushing the rupee in any direction.

Opinions are mixed on what RBI will do. Some institutions suspect a rate cut is on the cards - and this includes rating agency Moody's. On the other hand, the State Bank of India's chairperson says she doesn't think another rate cut is on the cards. My personal guess is that Raghuram Rajan will err on the side of caution once again because he has done so in the past.

The Bank Nifty Index will go through its usual gyrations until the RBI policy is announced. If RBI does cut rates, a rise of five per cent, that is another 1,000 points up on the Bank Nifty, could easily be on the cards. A hawkish stance might push the financial index down by the same amount or more.