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The Reserve Bank of India’s (RBI’s) monetary policy meeting on 20 September, helmed by new Governor Raghuram Rajan, will provide a first glimpse of his approach to tackling India’s growth-inflation dynamics and external vulnerabilities. Raghuram Rajan's priority of stabilising the Indian rupee, as stated on 4 September, seems to have been effective so far; both local and global developments have supported the Indian rupee recently. The market is also keenly awaiting his statement in order to assess the framework in which monetary policy will be formulated. In this context, Raghuram Rajan's strong emphasis on monetary stability – “to sustain confidence in the value of the country’s money” – will weigh on the market. In our view, monetary stability encompasses the twin objectives of containing inflation and arresting the slide in the Indian rupee (INR).
Despite the recent Indian rupee correction, Raghuram Rajan's task will not be easy: he has been in office for only two weeks, market expectations are unreasonably high, a key FOMC meeting takes place on 17-18 September, and WPI inflation ticked up in August. Market expectations range from a partial reversal of liquidity-tightening measures at one extreme to a repo rate hike to contain inflation risks at the other. Specifically, the market will be watching closely for any announcement of a timeline or preconditions that could lead to a reversal of the liquidity-tightening measures initiated in July.
In our view, the recent Indian rupee correction means further measures to stabilise the currency are likely to be deferred. Instead, the Raghuram Rajan might reiterate that measures announced on 4 September have succeeded in anchoring exchange-rate expectations, and that US dollar (USD) inflows in the next few months should ensure smooth funding of a narrower current account deficit.
A complete reversal of liquidity-tightening measures on 20 September looks unlikely to us. While the Indian rupee's 7.6% appreciation from 3-16 September is encouraging, the RBI might prefer to wait longer for confirmation of sustained currency stability – a factor that has been emphasised as a key determinant of such a reversal.
However, in order to reassure the market that these measures are temporary, the Raghuram Rajan might recalibrate some of its announcements. For example, it could reduce the daily minimum cash reserve ratio (CRR) balance from 99%, or marginally increase the liquidity adjustment facility (LAF) borrowing limit from 0.5% of net demand and time liabilities (NDTLs). These changes are unlikely to reduce the call rate substantially below the marginal standing facility (MSF) rate (currently 10.25%); but we believe they would offer some comfort to the markets, with the hope of further easing later.
We expect the Raghuram Rajan to sound a hawkish note on inflation. August CPI inflation remained elevated and the spike in WPI inflation to 6.1% raised concern about the future inflation trajectory. While the August WPI price pressures arose mostly from a temporary spike in vegetable prices, which we expect to wane in the next few months, the headline number is likely to keep the RBI cautious. Pass-through of higher import costs is not yet complete, and a one-off diesel price increase is still expected. We maintain that the pricing power of industrial products is extremely low – as evidenced in the 2% core inflation print – but Governor Raghuram Rajan is unlikely to focus on this. Markets will also be looking for an indication of his preferred gauge of inflation. They may respond negatively if the RBI’s concerns about high CPI inflation lead to expectations that CPI inflation will become the new nominal anchor.
In Raghuram Rajan's statement on 4 September, he highlighted containing inflationary pressures as a priority. This is in line with his long-held view of a monetary policy framework focused on a single objective, namely price stability or low and stable inflation. Raghuram Rajan has previously stated that there is no short-term trade-off between growth and inflation, and that low inflation also helps to stabilise the exchange rate without too much central bank intervention. Against such a backdrop, it will be difficult for the governor to strike a dovish note or turn more growth-focused. Raghuram Rajan has also highlighted fiscal discipline as a cornerstone of containing inflationary pressures and improving the conducting of monetary policy. The RBI may adopt a wait-and-see stance given that the government has yet to announce measures to contain the fiscal deficit at 4.8% of GDP – in the first four months of FY14 (ends March 2014), it reached a level equivalent to 60% of the budgeted fiscal deficit target.
Market is concerned about policy outcomes
Rates-market investors are positioned light ahead of two important policy announcements: the US FOMC and the RBI monetary policy meeting. The outcomes could lead to significant market volatility. We expect the US Fed to taper its quantitative easing by USD 10bn per month (USTs only) and maintain a relatively dovish policy tone. The RBI’s policy backdrop is somewhat more complex. If the RBI only fine-tunes the existing liquidity framework and reiterates its intent to gradually exit the tight liquidity regime, then we expect a limited market response. The markets will then watch closely for signals from the new Raghuram Rajan on the timeline and possible preconditions for a roll-back of liquidity-tightening measures. However, an announcement that underscores the risks of the re-emerging inflationary pressures may disappoint the rates market. The market would then price in a prolonged period of tight liquidity and high short-term interest rates. Given elevated uncertainty surrounding potential monetary policy responses, we remain Neutral on GoISec duration.
We have a short-term Neutral FX rating on the INR. Heading into Q4, we expect the USD rally to pause on stabilising data from China and an improvement in Asia ex-Japan trade balances, boosting the Indian rupee. An improvement in India's trade deficit should also be supportive. However, the crucial FOMC outcome may lead to considerable US dollar volatility ahead of this. Also, in his 4 September speech, Raghuram Rajan mentioned the possibility of further FX stabilisation measures being announced in the monetary policy meeting. The absence of this could dent the Indian rupee optimism that has been visible since his appointment.
By Standard Chartered