Steep rupee fall limits scope for rate cuts: Analysts

The steep fall in rupee in recent weeks is likely to delay the rate-cut cycle by the Reserve Bank as the decline will add to imported inflation, economists from three large foreign brokerages said today.

However, on the positive side, they said the bloodbath on the forex market may prompt the government to usher in more reforms like getting many of the pending bills passed and allowing FDI in many more sectors.

"From a monetary policy perspective, a weakening currency should delay the rate-cutting cycle as financial stability concerns override," Nomura India Chief Economist Sonal Varma said in a report.

British brokerage Barclays also said that though it maintains a tactical long rupee-dollar position, there are "doubts over the RBI's ability to lower rates at the upcoming meeting on Monday, despite weak growth".

Bank of America Merrill Lynch too is of the same opinion, saying though inflation reading has been positive for rate cuts, "the rupee volatility raises near term risk to inflation and to a rate cut this month."

However, Nomura noted the rupee fall has increased the likelihood of another round of reforms by the government."The weakening currency has increased the probability of another round of reforms...Some of the real sector reforms that we think are possible include clarity on gas pricing policy and ensuring coal linkage for power projects." The government may also raise FDI limits in sectors such as defence, telecom, asset reconstruction companies, private securities, and commodity exchanges among others to attract greater capital inflows, Varma added.

"Moreover, pending Bills reforms (land acquisition; FDI in insurance and pension; companies bill) could be taken up during the monsoon session," Varma added.

BofA-ML also noted retail inflation came in even below our and street expectations, leading to a more positive view on rate cuts but for the rupee which has lost 6 per cent since May.

Nomura, however, pointed out that the rate cut process will only be delayed but not scrapped given the weak growth outlook.

On the impact of cheaper rupee on inflation, the Nomura report said, "given a large share of global commodities in the headline inflation basket (around 35%), a depreciating rupee will add to imported inflation pressures."

"In coming weeks, we expect policy tools to be used to support sentiment, including further liberalisation of the capital account. Other possible measures may include limited RBI intervention, debt market liberalisation and a relaxation of FDI limits," Barclays said.

It said it maintains a tactical long rupee-dollar position at the moment as it doubts RBI's ability to lower rates next week despite weak growth.

Noting that the rupee is not the only emerging market currency that has been battered, BofA-ML said the debilitating impact of the higher CAD on rupee has come true with sharp currency depreciation of 6 per cent since May.

"Near term, the rupee will likely be volatile with global events and the RBI will have to instill confidence in the market," BofA-ML said.

Significantly, it also sounded confident that worst is over saying "most of the depreciation may be behind us as gold imports are coming down and are likely to fall further given measures taken by government; oil prices are stable; and government may be forced to raise flows through NRI bonds." As per Nomura's estimate, every 10% fall in rupee leads to 60-80 bps rise in headline inflation as imports would become costlier.

It, however, noted that manufacturers will absorb part of higher cost due to weak pricing power in the wake of sluggish demand.

On the current account deficit, Nomura said every 10% fall of the rupee will raise the CAD by 40 bps of GDP.

Similarly, it pointed out that 10 per cent rupee depreciation against dollar should raise the fiscal deficit by about 20 bps of GDP.

It, however, noted that given the threat of rating downgrade, the government would be prompted to stick to its budgeted fiscal deficit target by raising tax revenues.

The brokerage firm also said recent fall may delay the recovery process in the domestic economy. "Asset price volatility and a slowdown in capital inflows could hurt investment, as uncertainty would further delay a revival of the capex cycle," the report said adding that firms with unhedged forex exposure could suffer losses.