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RBI may cut rates as gold falls, oil slips

?We expect the RBI to tread with caution and cut rates by 0.25% in the upcoming policy?

As the RBI gets ready to unveil its monetary policy for fiscal year 2013-14, the expectations are huge as it comes in the backdrop of a sharp correction in gold and oil prices, the two biggest contributors to India?s Current account deficit (CAD).

This fall in commodity prices is accompanied with a lowest headline WPI inflation reading of 5.96 per cent in the last three years aided by sharp fall in food inflation in addition to slowdown in manufactured inflation. However, the other measure of inflation, Consumer Price Index (CPI), stays elevated at 10.4 per cent. Growth, as measured by GDP growth, is expected to remain low at 4.9-5 per cent for the full year in FY?13. The fiscal deficit seems to be have been trimmed significantly and stopped being a top consideration for policy rates for the time being.

With full year CAD expected to reach an all-time high of 5.1-5.2 per cent for FY?13, monetary policy decision become complex ? even though inflation may fall on account of domestic factors, imported inflation may rise as currency continues to weaken.

RBI highlighted the renewed importance of this variable in its January 2013 policy statement. And this is where a fall in crude and gold prices helps significantly. In addition to a direct fall in CAD, it leads to a fall in Wholesale Price Index (WPI) and also reduces subsidies on account of reduction in under recoveries in diesel and LPG prices leading to lower fiscal deficit.

Inflation, as measured by WPI, has shown a sequential improvement over the last fiscal. Core inflation (manufacturing inflation ex-food) has come off even more, indicating waning producers? pricing power. Food inflation though continues to be high owing to a not-so-good monsoon and continuous increases in minimum support prices (MSP) for agricultural commodities. A normal monsoon and a moderate rise in MSP this year can lead to a moderation in food inflation component in WPI and also CPI providing further room for RBI to loosen its monetary policy.

This leads to an obvious question: Can RBI do a lot in terms of cutting the rates? The answer is perhaps not.

First and foremost, one should keep in mind the fickle nature of markets. Oil prices can quickly recover what they have lost over last few days. The base case for oil prices will be derived from requirements of biggest suppliers of oil. For a lot of these suppliers the price below $100/bbl is likely to lead to budget deficits, which may not be a palatable outcome.

This would mean that oil prices may not be falling significantly from current levels. This, in turn, would mean further gains in fighting inflation may be limited for the time being.

Secondly, there is a significant element of suppressed inflation in our economy. There is large under recovery in diesel, LPG and kerosene. Domestic fertiliser prices are still significantly lower than the global prices. State electricity undertakings may need to undertake significant hikes in price of electricity to become economically viable on a standalone basis. All this is likely to tilt the balance of inflation upwards, despite cyclical factors.

Thirdly, there is a significant change in growth mix in favour of consumption as compared to investment over last couple of years. Such drop in investment in economy may be attributable to policy framework and uncertainty in economic environment that emanates from political climate. Due to coalition compulsions, the government pursued a bad mix of growth in favour of consumption for FY?11 and FY?12.

There has been some progress in FY?13 in taking some steps in improving the investment climate. However, a lot needs to be done to encourage investments further.

In the meantime, political uncertainty has grown with government losing DMK as an ally. There are fears for an early election. This may not portend well for investment climate irrespective of the budget incentives. Thus any rate cuts may boost consumption demand while not boosting investments in current context and as a result may be inflationary.

As a result, we expect the RBI to tread with caution and cut rates by 0.25 per cent in the upcoming policy. They may base the future rate cuts on sustainability of current oil prices, evolution of monsoon and government?s resolve to undertake further reforms and address supply bottlenecks. It may refrain from cutting (cash reserve ratio) CRR and use open market operations to manage system liquidity.

As far as other policy measures are concerned, we expect the RBI to cut the Hold to Maturity (HTM) limit for government securities for banks in line with reduced Statutory Liquidity Ratio (SLR), with an aim of spurring the banks to lend more and providing a boost to the sluggish economy.

We would also like to see if RBI announces some measures to discourage investments in gold and real estate and channelise savings into financial markets. Though we believe RBI has a limited role to play in this space and any steps to rein in real estate prices may not be viewed favourably in the light of promoting growth.

The author is Senior Vice President-Investments, ICICI Prudential Life Insurance Company Ltd.

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First published on: 29-04-2013 at 08:30 IST
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