The Monetary Policy Committee (MPC) decided to cut repo rate by 25 bps (4:2 majority) while keeping stance neutral (5:1 majority). The Reserve Bank of India has cut both its growth and inflation forecast as well. Prima facie there is nothing to complain in this policy. However, this is somewhat of a disappointment versus market expectations.
Although officially expecting 'only' 25 bps cut, participants were hoping for a simultaneous change in stance as well. An additional near-term drag has been the decision to allow another 2% of SLR as level 1 high quality liquid assets (HQLAs) for the purpose of calculating liquidity coverage ratio (LCR).
Ceteris paribus (with other conditions remaining the same) this is a disincentive for running excess Statutory Liquidity Ratio (SLR) to this extent, although the implementation being in stages may blunt this disincentive. Below are some of our key takeaways from the policy:
* Growth: The assessment on the global economy is that there has been further loss of pace in economic activity and that the slowdown is more synchronized. The assessment on India also doesn't sound particularly robust. High-frequency indicators in manufacturing are 'sluggish' whereas in the services sector, they suggest 'significant moderation in activity'. Credit flow has improved for large industries but remains tepid for micro, small, and medium enterprises.
Export growth is weak, while non-oil non-gold imports have declined sharply. The standout contrary data point here is that as per the RBI's order book, inventory and capacity utilization survey (OBICUS), capacity utilization has improved to 75.9% in Q3 from 74.8% in Q2, exceeding its long-term average. All told, GDP growth forecast for FY 20 has been cut to 7.2% with risks evenly balanced.
* Inflation: While food inflation is recovering somewhat, fuels group inflation has collapsed further. Core Consumer Price Index (CPI) has bounced around with mixed changes in underlying components. Notably, inflation expectations as per RBI's survey of households have fallen 40 bps further for each of the 3 months ahead and 1 year ahead horizons.
It may be remembered that in the previous round, expectations for 3 months had softened by 80 bps and 1 year by 130 bps. Thus this constitutes a reasonable softening of expectations since December. Additionally, input and output price expectations of producers in RBI's surveys have also moderated further. CPI projections have been revised further lower, to 2.4% in Q4 FY19, 2.9 ï¿½ 3% in H1 FY 20 and 3.5 ï¿½ 3.8% in H2 FY 20, with risks broadly balanced.
Importantly, forecast for Q4 FY 20 at 3.8% is still below the mid-point of RBI's target range. The accompanying monetary policy report (MPR) pegs Q4 FY 21 estimate at 4.1%. For FY 21 structural models indicate inflation will move in a range of 3.8 ï¿½ 4.1%, assuming a normal monsoon and no major exogenous or policy shocks.
Finally, the assessment ends with a very emphatic statement: 'The MPC notes that the output gap remains negative and the domestic economy is facing headwinds, especially on the global front. The need is to strengthen domestic growth impulses by spurring private investment which has remained sluggish.'
As discussed, the market has been somewhat underwhelmed by action versus its own expectations. When pushed about further rate action or the possibility of considering minor positive liquidity in order to facilitate transmission, the governor remained completely non-committal in the post policy meet. This is to be expected since the current action summarizes the sum total of all current deliberations and the governor is in no position to unilaterally commit to further action. However, it also served to pour near-term cold water on market's 'blue sky' expectations.
On the face of it, market is right to feel somewhat underwhelmed. As per RBI's assessment CPI will average 3.3% in FY 20 and around 4% in FY21, assuming a normal monsoon and no major exogenous or policy shocks. It is to be remembered that this is on the back of FY18 and FY19 already at below 4% average CPI. Given this, one may be justified in questioning the lack of more emphatic action.
If policy is being held back on account of less confidence on predictability, then it is the models that need more work. If it is on fears of shocks like monsoon, then the framework itself needs revisiting. This is because monsoons are an annual phenomenon. More importantly, they constitute a supply shock and so long as there is no second round effect from this, they should be looked through.
It is also possible that even though risks to CPI are stated as being balanced, RBI members privately think that they are skewed to the upside. The other curiosity is with respect to the growth forecast. Despite downbeat current assessment on local and global prospects, the RBI expects growth to accelerate from 7% in FY 19, to 7.2% in FY 20, to 7.4% in FY 21.
This very sanguine forecast may also be contributing to the lack of urgency to act more decisively even with CPI being very well behaved. Notably, the forecast acceleration is despite the forecast slowdown in global growth by international agencies, also quoted by RBI. Our most likely inference here is that the RBI's reaction function has indeed turned more emphatic under the new governor and this will continue to get further revealed in the months to come.
From a bond market standpoint, there is some near-term disappointment to contend with, given the expectations going into the event. However, given the global and local backdrop we expect the adverse reaction to be largely contained. Specifically, we expect there is more easing in the pipeline. The introduction of the forex swap tool for liquidity has had a very benign effect on short-end rates, given that it has caused hedge costs to fall by around 100 bps.
The spread between 4-5 year corporate bonds to 10 years has now risen to almost 70 bps. This may be a large reason why the 10-year may also tend to find anchor. Our preference remains for spread assets like SDL and AAA corporate at the 10 year point. Spreads versus underlying government bonds have shrunk versus what they were in early March, and we believe there may be more room to go, given the underlying environment and policy thrust on transmission.