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RBI to tighten stance from Aug 2018 onwards

Share Written By
Mr.Dhananjay Sinha

Head of Research, Economist & Strategist

31 Jul 2018

With RBI rate decisions now being guided by inflation targeting objective, the recent pick-up in inflation momentum will see the central bank hiking repo rate by another 25bps on August 1 to 6.50%.

With this, the RBI will move past the level last seen in Oct’16 when it had adopted a ‘neutral’ stance, implying that the next rate hike will be the first move towards a ‘tightening’ stance in the current cycle. We now believe that with the sharp rise in both CPI and WPI inflation, RBI may do a cumulative tightening of more than 50bps during the rest of FY19.

Retail (CPI) inflation continued to harden in Jun’18, rising to 5.0% yoy, along with persistent rise in core inflation at 6.4%. WPI inflation is at 5-year high of 5.8% yoy, picking up way beyond CPI inflation due to a sharper rise in commodity inflation.

Rising input prices and currency depreciation indicate build-up of inflationary pressure down the line. The combination of higher government spending ahead of the upcoming elections, its reflationary impact and re-emergence of margin pressure for the Manufacturing sector will increase both WPI and CPI headline inflation going forward. Also, increasing global trade restrictions and tariff hikes can impart further inflationary pressure.

We expect food inflation to rise in FY19 on the back of significant hike in MSP kharif prices (15%), higher government procurement and supply shortfall (due to lower kharif sowing area this year). Monsoon condition is normal this year (-3.5% below long period average as on July 18). Overall sowing during the ongoing kharif season at 63.1mn hectares is 4% lower than normal and -9.3% yoy. Farmers appear to have responded by lower sowing in crops that have seen weak realizations in the past, viz Rice (-12.4% yoy), Pulses (-18% yoy), Coarse Cereals (-10.6% yoy), Oil Seeds (below normal for the past two years). Sugarcane is the only crop where sowing is higher.

Liquidity tightness to intensify; RBI to resort to higher OMOs

Liquidity position, as per LAF, has been increasingly tightening in July. All the parameters till Jul’18, such as currency in circulation at 26.4% yoy growth and reserve money growth at 22.1%, are moving in line with our estimates captured in “India strategy: Yields to harden despite RBI’s OMO” (May 16, 2018). However, contrary to our expectation of FCA accretion of 5.0% in FY19, so far it has declined by US$19.4bn from Mar’18 end. These conditions indicate tight liquidity going forward and it needs to be supported by higher durable liquidity injection by RBI.

Our assessment of cyclical recovery in credit demand (15-16%), normalization of currency demand to pre-demonetisation trend and tapering of incremental foreign currency assets (FCA) are expected to push demand for reserve money to 24% in FY19E. The tightening global liquidity may lead to lower contribution of FCA to base money expansion, thereby increasing the burden on RBI to induce liquidity by way of monetizing G-Secs through OMO purchases and other money market instruments. Our estimate of OMO purchases of Rs2tn in FY19E was based on the assumption of a modest 5% rise in FCA; given the decline thus far, the risk is now on the higher side.

RBI has purchased Rs200bn through OMO till date, even as it’s incremental lending to the government, including OMOs, stands at Rs1.86tn. This is nearly 7.5 times the amount it lent during the same period last year. In our view, RBI is likely to get more aggressive on this front and might also announce a slew of liquidity measures.

Anticipated hikes in RBI’s policy rate, impending tightening in liquidity conditions going forward and hardening of global rates collectively portend implications for India’s G-sec yield curve in our view. Overall, we expect the G-sec curve to undergo bear flattening with 10-year fair value estimated at 8.4% (currently little less than 8%), along with the short-end aligning with repo rate hikes.

Rising credit demand reinforces our view of cyclical upturn, which will be dominated by well capitalized private lenders, including corporate banks that have geared themselves towards enhancing their retail franchise.