Reserve Bank of India surprises with a 50bps cut

The Reserve Bank of India (RBI) surprised with a 50bps cut in the Repo rate to 6.75% on Tuesday vs expectations of a 25bps reduction. This bunched-up move was likely driven by three reasons: a) comfort with the evolving inflation trajectory; b) preference to front-run impending US hikes later this year; c) jumpstart the domestic transmission process. 

Since the August review, most pre-conditions set out by the central bank have been fulfilled. The central bank's comfort on the evolving inflation trajectory was also reflected in the modest revision in the Jan-Mar16 inflation estimate to 5.8% from 6% earlier. CPI inflation remained below 4% in Jul/Aug and is likely to hold within 5.0-5.5% when base effects fade into the Dec15 quarter. Monsoon rains have been sub-par but fallout on the overall food basket has been contained yet far. 

Disinflationary impact from a weaker global economy and soft commodity prices also provide comfort that imported inflation will remain in check. As expected, the RBI moved its inflation target to 5% in Jan-Mar17 from 6% in Jan16. Given next year's target, it implies that one-year T-bill real interest rate of 1.5-2% is considered apt. 

Outlook on growth was relatively downbeat, faced with low capacity utilisation, weak investment activity, rainfall deficiency, stressed corporate/banks' balance sheets and subdued exports. Exports have declined for past nine months, offsetting the benefits from an easing commodity imports bill. Accordingly the GVA-based GDP estimate for FY15/16 was lowered to 7.4% from 7.6% in the Aug review. 

In its policy guidance, the RBI stressed that the stance will "continue to be accommodative, (with) the focus of monetary action for the near term will shift to working with the Government to ensure that impediments to banks passing on the bulk of the cumulative 125bps cut in the policy rate are removed". The largest public-sector bank responded by lowering its base lending rate by 40bps yesterday, taking cumulative cuts so far this year to 70bps.

"We expect this bunched-up rate cut, regular moral suasion and proposed regulatory changes to calculate lending rates, to improve the sensitivity of retail rates to policy changes in the coming months. We had expected cumulative 50bps cuts this fiscal year, with a 25bps cut in September. With the RBI's decision to frontload this quantum, a pause is likely to follow in December", notes DBS Group Research.

The central bank will remain data-dependent, with another window likely to open next fiscal year in case inflation surprises to the downside and external risks abate (including pending US hike). The RBI's main challenge will be to keep inflation close to 5% as impact of pay commission trickles in, base effects from low commodity prices fade and growth makes a gradual comeback next year. 

Concurrently, the RBI outlined a medium-term roadmap for foreign portfolio investments. The limit for FPIs into debt will be henceforth fixed in INR (instead of USD) and raised to 5% of outstanding government bonds by Mar18. Limits will be reviewed every six months. These changes open up room for INR 1.2trn additional flows by Mar18, with a near-term boost of about INR 240bn likely (USD 3-4bn). A separate limit has been set for state development loans.