In his inaugural speech, Dr Raghuram Rajan said that although he would seek to establish a coherent Reserve Bank of India (RBI) policy, "that is not to say that we will never surprise markets with our actions". He may just have done that with his first policy review where he cut the marginal standing facility (MSF) rate by 0.75 per cent while raising the repurchase (repo) rate by 0.25 per cent.
The net effect is to bring the MSF rate closer to the repo rate, reducing the differential to 200 basis points. Rajan also eased the cash reserve ratio (CRR) requirement in effect, by bringing it down to 95 per cent on tap with the RBI, versus 99 per cent.
The signals are clear. While the RBI will try to ensure that inter-bank liquidity is not too tight, it will also keep overall rates high in order to keep a grip on inflation. At the same time, it will revert to using the repo rate as the single key signalling rate by reducing the difference between MSF and repo. The State Bank of India (SBI) raised its own deposit rates the day before the monetary policy, which was an indication of where the RBI was headed. (Click for charts)
The markets should really not have been surprised. First, as Rajan said, the US Fed has only postponed tapering; it must eventually taper and it's up to the RBI to ensure the Indian financial sector isn't caught flat-footed when it does. The RBI will probably have to raise rates anyhow when tapering does come through and it may as well do so in staggered fashion.
Second, Rajan clearly doesn't like inflation - that is evident from his work. Given the rise in the wholesale price index to above six per cent and the stubborn reluctance of the consumer price index to drop below nine per cent, he has reasons to be disturbed. So, he is likely to push rates up until he's squeezed inflation expectations out of the system.
The man made his bones calling out Greenspan's policy when he predicted the sub-prime crisis well ahead of time at the former Fed Chairman's farewell party. So, he is not likely to be very bothered about the unhappiness his first policy actions have caused at the finance ministry or India Inc.
Although the RBI's actions seem rational, there was a big sell-off on Friday. The Bank Nifty crashed even before Rajan spoke, perhaps because the SBI rate hike served as an early warning signal. (The other possibility is that there was insider trading on leaks.) There are far too many optimists in the investment community and they were left desperately unwinding the long positions they had taken in the hopes of a rate cut.
In the short term, the RBI's tight policy runs counter to the Fed's genuinely surprising continuation of Quantitative Easing (QE) 3. Emerging market allocations were increased by foreign institutional investors (FIIs) once the Fed decided not to taper. FIIs have bought a net Rs 4,500 crore in the two sessions since the Federal Open Market Committee (FOMC) meeting ended. They have bought Rs 950 crore after the RBI monetary policy was announced. In those two sessions, the domestic institutions sold over Rs 2,500 crore (FII and DII data are provisional).
We may see this pattern of domestic institutional investors (DII) sales versus FII buying continuing to play out until the next FOMC meeting in late October when tapering may be on the table again. It will be interesting to see how and when the new Fed Chairman, whoever it may be, decides to unwind the tapering process.
As and when tapering unwinds, US bond yields are likely to spike further. There is a possibility that Japan will expand its own QE programme but that apart, emerging markets will surely suffer from lower FII allocations. If the RBI doesn't raise rates, there will be a flight of capital, with downwards pressure on the rupee.
Meanwhile, Europe is gearing up for German elections. It seems likely that Angela Merkel will be re-elected. But if she isn't, there will be nervousness about economic policy in the euro zone, given that Germany has effectively been a lender of last resort for the entire region.
On the domestic front, Assembly elections in five states are looming closer though dates are not yet decided. Among the two smaller states, Mizoram is not considered important in terms of national trends. But Delhi will provide an inkling as to where the urban vote may go next year. There is a chance that domestic investors will get very bullish if the BJP comes to power in Delhi and Rajasthan, while consolidating their hold in Madhya Pradesh and Chhattisgarh.
On the economic front, the weaker rupee seems to have helped exports expand while there has been a conscious attempt to squeeze imports and government expenditure. The current account deficit should reduce quite a bit in the second quarter (Q2). August may also have seen some sort of turnaround in consumer sentiment since auto sales went up by over eight per cent across all categories and passenger cars jumped 15 per cent.
There is a general feeling that Q2 earnings will be somewhat better than Q1. The festive season may see the usual boost to consumption during Q3. After that, easy money flowing out of election campaigns might keep things ticking over. On the other hand, gold imports will probably rise and petroleum prices might spike as fuel oil demand rises in the northern winter.
Technically, the market trend is difficult to call after a fortnight of violent fluctuation and two big sessions that went the opposite way on Thursday and Friday. There have been large net gains. But there was also a big sell-off on Friday. Tentatively, one would say things are a little bullish, given that FIIs (who may remain net buyers) have more money than DIIs (who will be net sellers).