Comment

Instead, it should position itself for a period of uncertainty

In hindsight, the Reserve Bank of India (RBI) has done the right thing by keeping interest rates status quo in its January 2008 policy review.

The market had built up expectation of interest rate cuts by the RBI, with the ten-year yield rallying 35bps from end 2007 to pre-policy date of January 28. It had also brought down the ten-over-thirty spread from around 38bps end-2007 to around 27bps pre-policy.

The dampening of rate-cut expectations saw the market reverse trends and the ten-year bond in currently trading around 15bps up from pre-policy levels while the ten-over-thirty spread has widened by around 23bps from pre-policy levels.

Looking at the present conditions in the financial markets, the RBI move looks logical and reasonable and the market should also play down any possibilities of rate cuts in April.

Since end January 2008, inflation as measured by the WPI (wholesale price index) is higher by over 1% from below 4% levels to above 5% levels. The INR has weakened by over 2% against the USD while the Sensex is down by over 11%. Oil prices are higher by 15% on the back of a weakening USD against the majors. The USD has fallen by 7% and 4% against the Japanese yen and the euro, respectively. The USD is looking to continue its downward trend with the Federal Reserve expected to cut interest rate by 75bps in their policy meet on March 18.

The IIP (index of industrial production) numbers for January 2008 came in at 5.3% against expectations of 8%. This has led to renewed demands for rate cuts by the RBI. However, the IIP numbers has shown a severe downtrend of 2% growth in capital goods sector, which has been averaging 18% for the period April to January 2007-08. This may be an aberration and February number may be a more accurate number to determine trends.

The current financial market conditions of a higher oil, rising inflation and a weakening rupee against a falling stock market and slowing growth necessitates the central bank to be extra vigilant against inflation and financial market instability.

Reducing rates will only weaken the rupee further while increasing the oil import bill, leading to a spiralling effect on the rupee. This will add to inflation against the backdrop of high food and commodity prices.

The RBI is better off trying to control foreign exchange inflows rather than outflows at this juncture. Slowing inflows is good for the economy as it will reduce cost of sterilisation, improve export competitiveness while keeping the rupee stable. The RBI can then look to loosen some of the liquidity measure done in the past. They can cut CRR (cash reserve ratio), loosen ECB (external commercial borrowing) controls and unwind MSS (market stabilisation scheme) bonds.

The market should not press for cuts but position itself for a period of uncertainty. Clarity will come down the line especially with global economic weakness bringing down demand for commodities leading to price declines and helping control inflation.

The author is head, portfolio management services, Sundaram BNP Paribas AMC Ltd. The views expressed by the author are his own and need not represent the views of the organisation in which he works.