Any increase in the already high 10 year yield, on SLR cuts, will delay lending rate cuts and constrain loan demand.
We continue to expect RBI Governor Raghuram Rajan to hold rates on August 5. That said, three questions arise. When will the central bank cut rates to support growth?
We do not see any material change to the June 3 statement that "…if the economy stays on this course (to eight per cent CPI-based inflation, or retail inflation, in January 2015), further policy tightening will not be warranted…" on Tuesday.
We expect the first rate cut in December, if rains normalise. Retail inflation will then likely slip below six per cent in November and settle about seven per cent by March.
A full-fledged drought poses a 250-basis point upside risk. True, the Narendra Modi-led government will likely combat agflation with supply side measures rather than RBI tightening a la the NDA regime of 1998-2004.
Still, this may push the first cut to early 2015.
Second, will the RBI moderate call rate volatility? We expect it to accord flexibility to either itself or banks to address genuinely unanticipated intra-week liquidity needs without forcing the money market to pay an additional 100 basis points at the MSF window.
The RBI could (1) raise the frequency of its floating repo auctions or (2) reduce banks' daily minimum balance to, say, 80 per cent of cash reserve requirements from 95 per cent now.
Finally, will the RBI continue to recoup foreign exchange reserves?
Yes, as it will need to buy $80 billion just to maintain the current not-really-adequate 8-month import cover in March 2016.
A bit of good news is that it has already mopped up $19 billion in forwards in May.
On balance, the RBI will likely hold the rupee at 58-62 if the dollar persists at 1.30/€ levels.
And can RBI stimulate credit offtake by cutting SLR again? Not really, at this stage of the cycle.
Banks' prime rates typically load 400 basis points over the risk-free 10 year G-sec yield.
Any increase in the already high 10 year yield, on SLR cuts, will delay lending rate cuts and constrain loan demand.
After all, banks would be unwilling to cut risk premium given the question mark over asset quality.
(The author is India economist at Bank of America Merrill Lynch.)
