The majority of the market is not expecting a rate cut in the 31st July policy review of the RBI while the minority is expecting a 25bps repo rate cut. SBI the largest bank by assets in the country is expecting a 50bps CRR cut, which a majority of the market disagrees. The reason the market is not expecting a rate cut is that inflation expectations are trending higher due to monsoon failure, with monsoons in India at 22% below normal as of July 2012.Inflation as measured by the WPI (Wholesale Price Index) stands at 7.25% as of June 2012 and is expected to trend towards 8% due to monsoon failure.
The market is looking at the wrong set of figures in not expecting rate cuts. RBI will look at the broad macro environment on the domestic and global front and will cut the repo rate by 50bps even as it lowers the GDP growth forecast to 6.5% levels from initial April 2012 forecasts of 7.5%. A repo rate cut of 50bps will bring down the repo rate to 7.5% from 8% levels and at this level it will be around average inflation expectations of 7% to 7.5% for full year 2012-13. An economy that is slowing down considerably from growth rates of 8.4% seen in 2010-11 to levels of 6.5% for 2011-12 and 2012-13 can live with negative real interest rates.
The banking aggregates data shows slowing down of the economy with aggregate deposits rising by an absolute amount of Rs 1,09,270 crores and bank credit growing by Rs 19,650 crores in the 30th March 2012 to 13th June 2012 period. Banks are parking money in government bonds as seen by the Rs 1,50,850 crores of investments in government bonds in the same period. Banks, especially Public Sector banks are cutting down on credit growth due to rising NPA’s and buying government bonds to park excess cash. The first quarter 2012-13 results of the banking sector showed rising NPA’s for banks from PNB, Central Bank and Union Bank indicating that more assets are going bad due to the economic downturn.
Global economy outlook is deteriorating. US second quarter 2012 GDP growth came in at 1.5% against growth rate of 1.8% seen in the first quarter of 2012. China’s second quarter GDP growth came in at 7.6% against 8.1% growth seen in the first quarter. Euro area manufacturing contracted in July 2012 for the sixth straight month. Central banks from China to South Korea cut rates unexpectedly to counter the sharp slowdown in growth.
RBI withheld rate cuts in its policy review in June 2012 as it had cut the repo rate by 50bps rate its April 2012 policy. RBI chose to cut rates by 50bps rather than 25bps each in April and June. The domestic and global economic outlook has deteriorated since April 2012. It is true rate cuts work with a lag but the cuts have to be deep enough to work. Economies across Japan, US, UK and Eurozone are facing weak economic prospects despite long periods of record low rates.
The fact that deteriorating economic growth is more harmful than a temporary spike in inflation due to weak monsoons will weigh on RBI’s policy decision in reducing rates by 50bps. The central bank will act according to the environment in which it is operating. Last year was a year of rising inflation and uncertain growth. This year it is a year of visible growth slowdown and uncertain inflation.
Bond markets are going into the policy with defensive positions. Ten year benchmark bond yields rose by 5bps last week with the 8.15% 2022 bond closing the week at 8.12% levels. Interest rate swap markets are more benign on rate cut expectations and closed flat to marginally higher week on week. Corporate bond yields fell across the curve on expectations of better liquidity conditions while money market securities yields fell sharply on improved liquidity outlook. A 50bps rate cut will bring down yields sharply across the market.
Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI eased by around Rs 21,000 crores last week. Banks demand for funds was lower in the second week of the reporting fortnight leading to liquidity easing. Liquidity is likely to ease further in the coming weeks on reduced demand for funds from the system given the slow pace of economic activity.
Government bond auctions
The government auctioned Rs 15,000 crores of bonds last week. The bonds auctioned were the 8.07% 2017 for Rs 4000 crores, the 8.15% 2022 bond for Rs 6000 crores, the 8.97% 2030 bond for Rs 3000 crores and the 8.33% 2036 bond for Rs 2000 crores. The cut offs came in at 8.06%, 8.11%, 8.46% and 8.55% respectively. The government is scheduled to auction Rs 15,000 crores of bonds this week.