The Reserve Bank of India (RBI) last cut repo rate in April 2012, when it was reduced by 50 bps. The central bank is likely to cut repo rate by 50 bps in its mid-term review of its annual policy on Tuesday even as it may revise GDP growth estimates from 6.5% to 6%.
RBI will likely state that rate cuts are necessary to keep GDP growth at reasonable levels and not let it fall off the cliff. Bond markets, especially government bond markets, will react positively to any rate cuts, leading to a 25 bps fall in yields.
The RBI policy review meet has a divided market on expectations from the policy. There are expectations of a 25 bps repo rate cut and there are expectations of a 25 bps cash reserve ratio (CRR) cut. A small section of the market is expecting a 50 bps repo rate cut.
The bond market positioning going into the policy suggests that the market expects a rate cut and will be indifferent if it is a repo rate cut or a CRR cut. The benchmark ten-year bond, the 8.15% 2022 bond, yield closed flat week on week at 8.13% levels, indicating that the market is comfortable at current levels of yields and there has been no aggressive bullish or bearish positioning. The yield on the 8.15% 2022 bond has fallen by around 5 bps since the last policy review in mid-September on mild rate cut expectations.
The OIS and corporate bond yield curve suggest that RBI could be more aggressive on rate cuts. The five-year OIS yield at 7% levels is around 107 bps below the five-year government bond yield. The high spread indicates that the OIS market is front running a weak economy and subsequent monetary easing. Corporate bond yields at around 8.90% levels for the five- and ten-year AAA rated bonds are down by 30 bps over the last two months, leading to credit spreads compressing by around 30 bps and 20 bps, respectively. Falling credit spreads indicate expectations of lower interest rates and higher liquidity.
The case for a CRR cut is due to tightening of liquidity over the last two months. Liquidity, as measured by bids for repo in the liquidity adjustment facility (LAF) of the RBI, averaged Rs85,000 crore on a daily basis last week. Liquidity deficit has increased by around Rs40,000 crore over the last couple of months, despite a 25 bps CRR cut in the September 2012 policy review.
Monetary aggregates point to weak credit and deposit growth and falling money supply growth. Credit growth at 15.9% on a year-on- year basis as of October 5, 2010, is down from levels of 16.9% growth seen in end-August 2012. Deposit growth at 13.9% year on year is down from 14.7% levels seen in end-August. Broad money supply (M3) growth has come off from 13.7% growth seen in end-August to 13.3% growth as of October 5.
The domestic and global economies are exhibiting weakness with growth forecasts for 2012 being revised downwards by various think tanks. The IMF has projected an extremely pessimistic growth forecast of 4.9% for India against other forecasts of 5.5% to 6%. IMF has cut global GDP growth for 2012 as well as 2013, indicating pessimism in economies from China to Brazil.
RBI will take both domestic and global factors into consideration when taking a policy decision on the October 30. Slowing monetary aggregates, tight liquidity conditions and clear signs of weakening global economy do call for rate cuts. The only factor that is going against rate cuts is inflation. Inflation as measured by the wholesale price index (WPI) came in at 7.81% for September 2012, a calendar year high. Inflation expectations in India are on the higher side rather than on the lower side and this is largely due to a slow pass through of administered prices into the economy.
The rupee has given up around 2.8% gain against the US dollar since the beginning of this month. The rupee at around `53.6 levels is down 10% on a year-on-year basis though it is up by 6% from lows seen in June 2012. RBI will weigh the effect of its policy actions on the rupee. A rate cut can boost growth sentiments leading to more dollar inflows and this can pull up the rupee and help neutralise a current account deficit that stood at 3.9% of GDP as of end June 2012.
The writer is the editor of
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