Gyan Harlalka
The RBI kept the key rates unchanged?in this mid-quarter review?meeting, in line with market expectations. Despite the pause taken by the RBI, the policy stance is less hawkish and quite accommodative as compared to previous occasions. The RBI said that durable receding of inflation and balance of payment situation will determine further action, as compared to prior policy statements highlighting the limited room for policy easing. This was greeted with a positive reaction in the government bond markets as yields fell across the board. However, the market gave up all the gains and reversed, post the recent US Fed meeting.
It is quite clear that the RBI would like to keep current account deficit (CAD) and balance of payments (BoP) situation in check, while inflation concerns, which have been a long-standing line of thought among RBI officials, seem to be moderating.
The largest components of our imports are oil and gold. The fall in oil and gold rates earlier this year, were expected to provide a much needed succour to the CAD. However, unexpectedly, the sharp fall in gold prices ? after a continuous rally for the past 12 years ? sparked a massive buying spree in India. India also continues to import large quantities of oil to satisfy its growing demand. These combined with the large outflow from FII customers led to the sharp depreciation in the rupee.
Inflation ? a key concern of the RBI – continues to print lower. May WPI was at 4.70% and core inflation is at 2.3%. There is a positive base effect which will help WPI to trend further lower in coming months. Given the good start to the monsoon which may result in lower food inflation this year as well as a high base effect, we should see WPI inflation remaining below 5% levels for rest of the year, which is within the RBI?s comfort zone. The recent upgrade by Fitch in India?s rating outlook is a positive signal as well.
On the macroeconomic outlook, the RBI expects softer commodity prices and curbs on gold imports to impact the FY 2013-14 CAD favourably. Once the CAD stabilises and volatility in the rupee reduces, we expect the RBI to deliver another 50 bps cut during rest of the year, i.e. our target for the repo rate is 6.75% by year-end. Given lower inflation and lower growth rates (Jan-Mar quarter GDP growth at 4.8%, marking consecutive quarters of sub 5% growth), we expect the likelihood of a reduction in policy rates getting stronger soon.
There may also be possibility of shift in liquidity corridor in coming months, through OMOs & CRR cuts. This could also herald an era of low rates. Currently the liquidity deficit is R60,000 crore, but with a few OMOs and some CRR cuts, we may see this moving to a surplus situation.
Though domestic factors have started turning positive on the macroeconomic front, the global markets got impacted post the FOMC meet and US Fed chairman Ben Bernanke`s speech last week. While the policy rates were left unchanged, Bernanke, appeared more hawkish that previous occasions. He gave more details on possible asset purchase tapering and exit principles. The statement emphasised that not only the risks on economic outlook have reduced, but they have diminished for the labour market as well. The average for the unemployment rate in Q4 2013 was cut from 7.4% to 7.25%. On cue, the US 10-year Treasury broke through 2.30% while the swap curve moved up and steepened.
With a positive outlook on the US economy, and a higher probability of tapering of QE in Q4 2013, FII investors will find the US market more attractive than emerging markets in the short term. We have already seen outflows from the debt investment portfolio, and it is more likely that we see some pressure on the equity investment portfolio as well soon.
The pressure on balance of payments has increased with the further weakening of the rupee against the dollar, akin to all global currencies. This impact will be balanced to some extent by the correction in commodity prices, primarily gold and crude oil. With a weaker rupee, we do expect exporters to gain significantly, and we should see an increased selling of dollars from them. The five-year USD/INR forward rate is presently working out to 75 levels, which is attractive to lock in for exporters with long tenor contracts. The rupee should stabilise near the current levels for the medium term.
A weak rupee makes India even more attractive to international investors for the long term. With inflation under control, and growth bottoming out, and a higher probability of the RBI cutting rates, all domestic asset classes should perform from these levels, as the inherent strength of the economy makes India more attractive in the long term.
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The author is MD and head, markets, RBS India
