The Monetary Policy Committee (MPC) surprised market expectations by keeping policy rates on hold by a vote of 5:1. The member voting for the hike was external member Ghate. Notably, even the most hawkish RBI member, Patra, didn’t vote for a hike. The stance has been changed from ‘neutral’ to ‘calibrated tightening’. Again, the vote on stance change was 5:1, with one external member Dholakia voting to keep the stance unchanged.
Key points are as follows:
1. On Consumer Price Index (CPI), MPC acknowledged that ‘food inflation has remained unusually benign, which imparts a downward bias to its trajectory in the second half of the year’. The risk to food inflation from spatially and temporally uneven rainfall is also mitigated, as confirmed in the first advance estimates for production. The Reserve Bank of India (RBI) has taken into consideration increase in Minimum Support Price (MSP), the USD 13 per barrel rise in India crude basket since last policy, the currency depreciation, and the impact of HRA from Pay Commission. After all of this, CPI is projected at 4% (4.6% estimated in previous policy) Q2 FY19, 3.9 – 4.5% (4.8%) in H2, and 4.8% (5%) in Q1, FY 20. Excluding HRA, CPI is projected at 3.7% (4.4%) in Q2 FY19, 3.8 – 4.5% (4.7% – 4.8%) in H2, and 4.8% (5%) in Q1 FY 20. Risks have been changed from balanced to ‘somewhat to the upside’.
2. GDP outlook is being aided by robust private consumption, although the rise in oil prices may impact disposable incomes. Improved capacity utilization, larger Foreign Direct Investment (FDI) flows, and increased financial resources to the corporate sector augur well for investment activity. However, the tightening in local and global financial conditions may dampen investment activity. Export outlook is uncertain as tailwinds from recent rupee depreciation could be muted by slowing of global trade and the escalating tariff war. Basis these, GDP growth projection for current year is retained at 7.4%, while Q1 FY 20 has been cut by 0.1% to 7.4%. Risks here are broadly balanced.
3. A Voluntary Retention Route (VRR) has been introduced for foreign portfolio investors (FPIs) where they need to voluntarily commit to retain in India a minimum required percentage of their investments for a period of their choice. FPIs would apply for investment limits under the Route through an auction process. Under this, they will have more operational flexibility in terms of instrument choices as well as exemptions from regulatory provisions such as the cap on short-term investments (less than one year) at 20% of portfolio size, concentration limits, and caps on exposure to a corporate group (20% of portfolio size and 50% of a single issue).
Takeaways
The policy today is very consistent with our core view as expressed in recent communications (please refer “Too Tight? A Market Update,” dated 24th September for details). We had said there “in our view, one should expect less and not more hawkish outcomes of policy relative to expectations. Hence, it is very likely that market is overpricing future policy hawkishness (on liquidity and rates) especially in light of recent events”. Since then the RBI has surprised markets in proactive liquidity steps (Liquidity Coverage Ratio (LCR) dispensation, Open Market Operations (OMOs)) and today surprised on rates as well.
The RBI / MPC action has to be looked at in two ways: One, this recognizes that substantial financial tightening is already underway and this doesn’t need additional help from policy. Two, it pushes against the notion that an interest rate defense is required for currency. We have argued against the interest rate defense logic previously (please refer our note “Back to Bedlam? A Bond & Macro Update”, dated 6th September for details). The starting point of real interest rates is much different than 2013 and an interest rate defense now is possibly a rethink on the whole CPI targeting framework. The Governor made it abundantly clear that RBI doesn’t take a view on the level of a rupee and only curbs volatility; and that interest rates will respond to the anticipated impact on CPI of currency depreciation, as any credible CPI targeting mandate should.
Finally, the commitment to provision of adequate liquidity has been reiterated including the provision of adequate reserve money to meet the economy’s demand.
Conclusions
A rate pause today doesn’t mean that the rate cycle is done. Given extreme uncertainty on currency and oil, there is still a possibility that upside risks indeed materialize. It is for this reason that stance has been changed; to indicated readiness to respond if required and to convey that there is absolutely no chance of a cut in the foreseeable future. We also retain an expectation of up to 2 hikes by the end of the financial year as of now. Even with that, and accounting for the INR 1,00,000 crore plus OMOs that we expect till March, front end rates are looking quite attractive. Preference, as expressed before, runs from sovereign to AAA with an explicit reiteration of caution here for lower rated / high yield strategies; given the rapidly deteriorating financing environment.
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