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3rd May 2017 | Dubai
In their report, Emerging Insight: Three reasons RBI could cut rates in August, Bank of America Merrill Lynch’s India Economist Indranil Sen Gupta outlines the following.
India in Focus
We continue to expect the RBI monetary policy committee to pause on 6 June and cut rates by 25bp on 2 August. As it has just hardened its stance, the RBI will likely wait for transfer of the ‘special’ dividend to the fiscal from demonetization and good rains before cutting in August. Why? First, growth remains weak. Old series GDP growth is running at 4.5-5.0%, well below our estimated 7% potential/trend. In fact, the RBI’s own capacity utilization indicator is stagnating at 70-75%. Second, we see inflation averaging 4% in 1H17, well below the RBI’s 2-6% mandate. Core inflation has slipped to 4.2% from 4.8% in October, when the RBI cut the rates. Daily data show that food inflation is actually slipping. Finally, the rate cuts will allow the RBI to recoup FX reserves by attracting foreign portfolio investors’ (FPI) equity flows by supporting growth. While INR has strengthened to Rs64/USD, seasonality will turn against it in coming weeks. Our Asia FX strategists see Rs66.75/USD by December.
#1. Weak growth: lending rate cuts key to recovery
We continue to highlight that lending rate cuts hold the key to recovery. We do not share the RBI’s concern that “… at the same time, the output gap is gradually closing. Consequently, aggregate demand pressures could build up, with implications for the inflation trajectory…” We estimate that the old series GDP growth at 4.5-5%, is well below our estimated 7% potential/trend (Chart 1-2). It is statistically difficult to work out potential growth in the new GDP series without past data. In addition, all related metrics – industrial production, credit growth, earnings – are running well below their medium-term averages. Industrial growth, at -1.2% for February and 0.6% in FY17YTD, down from 2.5% last year, is far below the medium-term average of 5.7%. Finally, the RBI’s own capacity utilization indicator is stagnating at 70-75%. In tandem, investment has collapsed to 28.7% of GDP from 32.7% in March 2014. A recent RBI study also confirmed the slack in the system.
#2. Benign inflation: 4.2% core CPI
Inflation should remain well within the RBI’s 2-6% target range (Chart 3). We see inflation averaging 4% in 1H17, well below the RBI’s 2-6% mandate. Core inflation has slipped to 4.2% from 4.8% in October, when the RBI cut rates. Daily data show that food inflation is actually slipping (Table 1). Based on sowing data, we expect bigger oilseeds (6%) and pulses (11%) rabi summer crops to pull damp prices further.. While sugar acreage has shrunk, sugar prices are coming off on ample stocks. The Australian weather bureau sees a 50% chance of El Nino developing in 2017 but the Met has forecast normal rains of 96% on average.
With 7th Pay Commission arrears paid in October, the second round inflationary effect of higher house rent allowances – the first round is surely statistical – is unlikely to be major. While El Nino remains a risk, the RBI itself recognizes that proactive supply management will have to play the critical role in containing the inflation impact in such a case.
#3. RBI to recoup FX reserves
Rate cuts will allow the RBI to recoup FX reserves by attracting FPI equity flows by supporting growth. While INR has strengthened to Rs64/USD, seasonality will turn against it in coming weeks. Our Asia FX strategists see Rs66.75/USD by December.
We expect the RBI to continue to buy FX reserves to insure against global volatility. INR typically strengthens, seasonally, in February to mid-April (Chart 4). Looking beyond, Gov. Patel will likely want to recoup FX reserves as the FPI portfolio has jumped to about 120% of FX reserves from 80% in 2007-08. Yes, the import cover looks comfortable at about 10 months on a 1-year forward basis, well above the 8 months we deem required for INR stability. This, however, largely reflects the drop in oil prices, as well as weak import demand due to slow growth rather than any fundamental improvement in FX reserves. In addition, the central BJP government is likely to conservatively build up FX reserves, as demonstrated during 1999-2004, when Gov. Jalan accumulated FX reserves and, 2014-15, when Gov. Rajan also bought FX. Finally, it is highly unlikely that the RBI will hurt growth by strengthening INR when inflation is set to average a benign 4% in 1H17. Although WPI inflation has expectedly risen to 5.7% on higher oil prices, base effects will pull imported oil price inflation down in coming months.