Sonal Varma
The RBI has left the reverse repo, repo and cash reserve ratio (CRR) rates unchanged at 6 per cent, 7.75 per cent and 7.5 per cent respectively as most economists expected, although the markets had priced in an interest rate cut in the wake of the US Fed’s 75bp cut.
The RBI retained its GDP forecast at 8.5 per cent for FY-08 and its wholesale price inflation (WPI) forecast of “close to 5 per cent”. The overall policy stance remains one of enhanced vigilance in the light of the risks from a sharper-than-expected US slowdown and financial market instability on the one hand, and higher inflation, on the other.
The RBI noted the downside risks to GDP growth stemming from overseas, but balanced this by sounding hawkish on the upside risks to inflation.
The outlook is more fluid than usual and will depend heavily on external conditions. The RBI is ready to act swiftly, should either rising inflation or slowing growth start to dominate.
Strong capital inflows
We expect India to attract strong capital inflows, resulting in 100bp-worth of hikes in the CRR by March 2009 to mop up excess liquidity. At this juncture, the RBI may keep policy interest rates unchanged in FY-09, but should the US team start forecasting a recession, we would most likely pencil in a rate cut in April.
Given the highly uncertain external outlook, the RBI said that it was ready to respond swiftly, if and when required. It emphasised that the global decoupling thesis for emerging market economies was yet to be tested.
While India’s external trade is well diversified, the RBI warned that the high forex exposure of large corporates and possible capital flight during times of high risk aversion could hurt India’s equity market in particular.
The central bank has raised concerns that the period of subdued WPI inflation could soon come to an end, partly due to base effects but also driven by delayed pass-through of high food and energy prices, uncertainty over agricultural output, a possible surge in public sector wages, and rising domestic liquidity, highlighted by the 30 per cent y-o-y growth in reserve money in December. The implication is that real interest rates are set to decline, even with nominal rates unchanged .
We expect GDP growth to moderate from 8.9 per cent in 2007 to 8.5 per cent in 2008 and WPI inflation to pick up from 4.8 per cent to 5.3 per cent. However, the outlook is uncertain: We see downside risks to our growth forecast and upside risks to our inflation forecast.
Interest rate cuts
Based on the view that the US Fed cuts rates by a further 100 bp to 2.5 per cent by year-end and successfully averts a recession, we expect India to attract massive capital inflows, flooding the economy with liquidity, adding inflationary pressures and forcing the RBI to hike the CRR by 100bp by March 2009.
In this base case, the RBI may keep interest rates unchanged.
However, the US economy is only one shock away from recession (it attaches a 40 per cent probability of recession), in which case we would lower our GDP growth forecasts, expect weaker capital inflow, and a more benign inflation outcome.
Reflecting this fluid situation, there is a 50 per cent probability of the RBI staying on hold at its April meeting, with a 40 per cent chance of a cut and a 10 per cent chance of a hike.
The author is Economist, Lehman Brothers.
