Better rate differentials to help Indian asset markets withstand weak risk uptake
The Reserve Bank of India’s (RBI) monetary policy committee lowered the benchmark repo rate by 25bps to 6.25% at its first meeting on Tuesday. This was along our expectations. The accompanying statements were neutral, as the panel reinforced the early-2017 inflation target of 5% but with modest upside risks. Growth and inflation projections were held unchanged. Inflation path vs global watch factors Over the next two quarters, the policy committee will have to weigh the domestic inflation outlook against global risk factors. Domestically, inflation is set to moderate over the next two quarters. From an average 5.6 per cent in April-August 2016, we expect CPI inflation to average 4.5 per cent in the December 2016 quarter before inching up to 5 per cent in the March 2017 quarter. Hence, full-year inflation will not be far from the 5 per cent target for FY16-17 (April-March). The sowing of summer crop looks encouraging. There was a double-digit increase in the acreage of pulses this year. Supplies are expected to improve from October onwards. Additionally, a normal southwest monsoon and improving reservoir levels are expected to be supportive of the winter crop, keeping food inflation in control. Services sector inflation moderated between 3.5-4.0 per cent and weaker still if we exclude the impact of gold prices under the personal care and effects segment. The base effect from low commodity prices are likely to wane but this is partly offset by the higher retail fuel prices (thanks to imposition of excise duties) vs global crude costs. A positive inflation path however needs to be weighed with global uncertainties ahead. This include German/European banking sector worries, Italian referendum, US Presidential elections in November, an Opec meeting later that month and the likelihood of US Fed rate normalization in December. Brexit deliberations might start in early-2017, posing another challenge to global risk uptake. Unlike in the past, we don’t expect RBI to reverse course (to hike) if these factors weaken risk appetite. This is because India’s rate differentials vis-à-vis US treasuries are still relatively wide despite notable improvements in India’s macro outlook. This should help the Indian asset markets withstand bouts of weak risk uptake. But, cutting policy rates in the face of a deteriorating risk environment is ill-advised. Hence, we expect RBI to stay on hold for rest of this year, with a small probability of another measured cut in Q1 of FY17, subject to external developments. The inflation dynamics are likely to change as we head into FY17-18, as highlighted below. RBI and government: the need for collaboration Awaiting the official word, we assume that the 4 per cent (+/- 2 per cent band) will be adopted as the CPI target for FY17/18, as and when the related RBI Acts are amended. While we are comfortable with the inflation outlook for FY16/17, keeping CPI inflation stable around its 4±2 per cent target band next year will be a challenge for the central bank and the government. Aggregate demand will be higher in FY17/18 due to a normal monsoon; salary increases from the seventh Pay Commission, and steady-to-higher food prices from structural inadequacies. Implementation of the Goods and Services tax will also temporarily lift price pressures. Importantly, the 4 per cent inflation target implicitly holds RBI responsible for the direction of food prices, the largest component in the CPI basket. As witnessed in the past three years, RBI had little direct control over the price increases of cereal in FY11-12, vegetables in FY12-13, and pulses last year. Food inflation is also keeping rural inflation higher than urban inflation. Since early 2016, rural inflation has been close to 6 per cent, with urban inflation averaging 150bps lower in the sub-5 per cent region. Higher inflation has started to hurt demand in the rural sector with no signs of letting up. Structurally, the government has been playing its part to keep inflation stable. Having met its fiscal targets for FY15-16, the government is targeting a smaller deficit this year. Taking advantage of low commodity prices, diesel subsidies were lifted. Pay Commission hikes have been partially implemented, which will smoothen the impact on the fiscal books and inflation. The minimum support prices for agricultural produce were raised modestly, down from double-digit increases in the past. Administrative measures to curb hoarding/malpractices were also taken. Investments into infrastructure are under way, particularly into roads, highways, ports etc. More work is required on this front, especially on improving ex-farm to consumer supply chain to ensure supplies can be stepped up in case of need. It is important that this collaborative approach remains on track even when demand improves, commodity cycle turns up or the political calendar gets busier. In summary With the interest rate setting policy decision shifting to a policy committee, markets will seek clarity and transparency in communication to better gauge the panel’s leanings. While the FY15-16, the CPI target of 5 per cent appears within reach, achieving and maintaining inflation at 4 per cent next year appears to be a challenge. RBI has been tasked with setting inflation targets, but requires the government’s collaboration to meet and maintain the 4±2 per cent target band until 2021.