FORGET REPO RATE CUTS FOR NOW

The Reserve Bank of India (RBI), which meets today for a mid-quarter review, is unlikely to relent. It will
hold the Repo rate at 7.25%.

A poll by a popular Hindi Business Channel puts the expectations of a Repo rate cut at 30% and a CRR cut at 25%.We think the RBI will simply hold its horses for the moment.

There were little expectations of any rate cut before the WPI data came in. The May WPI came in at 4.7%  against expectations of 4.8% and April’s 4.89%. The core inflation came in at 2.4%, much lower than April’s 2.8%. This favourable data has made some analysts dream of a cut.

We believe that the RBI is unlikely to get carried away by this data, as it more worried about the larger issue of debt money flowing out of the country.

Debt market investors look for higher yields with in their risk tolerance. It made sense of FIIs to invest in Indian paper as the yields were higher before the RBI began cutting rates. These rate cuts have made it less attractive to the FIIs.

More importantly, the yield on the 10 year US treasury has been risen from 1.7% to 2.25%.This has further reduced the attractiveness of the Indian debt. Add to that the risk of a depreciating currency. The cost of hedging the currency risk has gone up substantially further eroding the yield differential.

On top of this if the RBI were to cut the Repo Rate, the yield for existing debt investors will further go down. This will result into a selloff in the bond market and currency will plummet, which will hurt the equities markets.

Large sales in debt market will raise the yields for new debt investors. But they will stay in the side-lines, till they develop confidence in the currency that it is not going to further weaken from here.

The RBI will not take this risk. So any hope of repo rate cut is out of the window.

The RBI, however, could relent on a CRR cut. But here the central bank does not have the advantage of an improving data, which is there for a repo rate cut in the form of fall in the core inflation rate. Liquidity in fact has improved in the month of June. The advance tax has taken away some liquidity but this is temporary. But if the Government is serious on the food bill, then this CRR cut will also go out of the window.

A depreciating Rupee, food inflation and deteriorating Current Account deficit will all weigh on the RBI when it meets today. He is going to throw the ball back in the court of the Government to act. And if it does not act, then in 2014 the ball will be in our hands and we will act for sure.

VK Sharma