Reserve Bank of India ‘front-loads’ a rate cut to accelerate economic recovery

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On 29 September the Reserve Bank of India (RBI) cut its key policy repo rate by 50bp to 6.75%. While the rate cut was expected, its size – 50bp rather than the usual, more pedestrian 25bp – is surprising. In our view, the RBI took advantage of the favourable inflation outlook to ‘front-load’ a rate cut and help accelerate the Indian economic recovery in a context of slowing global growth. The RBI now expects India to grow at 7.4% as measured by Gross Value Added (GVA) for the financial year ending in March 2016 (FY 2016).

 

Extending the rate-cut cycle

Following its monetary policy review on 29 September, the RBI reduced its key policy repo rate by 50bp to 6.75%. This was the fourth rate cut this year, an accumulated total of 1.25%. The RBI also lowered the reverse repo rate and marginal standing facility (MSF) to 5.75% and 7.75%, respectively, while the cash reserve ratio (CRR) remained unchanged at 4%. Lastly, the RBI presented a roadmap to lower the Statutory Liquidity Ratio (SLR) – which currently stands at 21.5% – by 25bp every quarter over the period of Q1 2016 to Q1 2017.

Macroeconomic stability: conditions met

The RBI’s move is, in our opinion, justified by a number of factors. Firstly, consumer price  inflation (CPI) has remained below 5% despite a below-average monsoon season (the level of rainfall being critical to India’s level of food production). Secondly, the inflation outlook appears comfortable given the weakening global growth outlook which is likely to result in persistently low commodity prices. The RBI is now confident it will reach its 6% target for January 2016, and set a target of 5% inflation by March 2017. The RBI is also reassured by the government’s commitment to continue fiscal consolidation, with a deficit target of 3.9% of GDP for FY 2016 and an objective of 3% by FY18.

Accelerating growth

Lastly, the RBI expects the front-loading of rate cuts to accelerate the transmission of monetary policy to banks and provide greater policy certainty to help the revival in private investment. Since the first rate cut in January 2015, the average base lending rate of banks has only decreased by around 30bp, while the RBI has lowered the repo rate by 75bp.

While India is expected to become the fastest growing large economy this year ahead of China, the pace of recovery so far has been a bit slower than expected and the RBI now expects India’s GVA to grow at 7.4% in FY 2016, down from 7.6% previously. Pending better monetary policy transmission and a pickup in private sector investment, the RBI expects GVA growth to accelerate to 8% by Q1 2017.

Further moves to be data-driven

After this 50bp policy rate cut, the RBI expects that “given our year-ahead projections for inflation, this ensures one year expected Treasury bill real interest rates of about 1.5%-2.0%, which are appropriate for this stage of the recovery.” Accordingly, further monetary policy action is likely to be driven by changes in the inflation outlook along with the RBI’s disinflationary path.

Earnings growth to drive performance

The RBI move is expected to help the gradual recovery in corporate earnings growth. While earnings growth was broadly flat in FY 2015, a closer look helps identify a more differentiated reality. Within the 50 largest Indian companies, the top 20 companies by earnings growth grew earnings at 23.0% in FY 2015, while the bottom 20 experienced a 25.5% average decline, opening interesting stock selection opportunities for active managers.

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Paul Milon

Investment Specialist, Indian Equities

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