Global slowdown & RBI credit policy status quo

Advent of New Year witnessed fresh reporting of heavy losses by financial majors resulting in more than 10% fall in global equity indices. US Fed, focused on heading off a recession once again succumbed to the demand of financial market by cutting their target for the overnight lending rate by half a percentage point. The action was in addition to the surprise 75 basis points reduction in the third week of January. Fed has so far cut the benchmark rate by 225 basis points since Sept’2008 down from 5.25% to 3%. It is to be noted that policy action has come with a caveat that the downside risk to growth remain signaling further rate cuts in future

Fed Fund futures are already discounting further rate cut of 75 basis points by July’08. However its pertinent to note that inflation number in US is not benign at above 4%. In case the fear of confirmed recession in US economy is unfounded or signs of recovery are seen, it may lead to sudden reversal in Fed action on accommodative policy

Unchanged local interest regime:
Amidst increasing monetary easing by central banks in developed markets to assuage concerns of economic slowdown and credit crunch, Indian Central Bank has stuck to its domestic theme. RBI in its January policy has maintained status quo in terms of policy direction and highlighted liquidity management, upward inflationary risk and growth moderation in certain industrial segments

Recent months witnessed liquidity tightness due to repetitive CRR hikes, MSS auction, and outflow on account of IPOs. This led to RBI infusing liquidity through Repo auctions. So fare RBI has been successful to moderate inflation and credit off-take without affecting growth rate. Recent sharp rate cuts announced overseas and dovish views expressed by ministry officials had infused the rate cut expectations among a segment of market. Against this background, policy seems to be a dampener for exuberance exhibited in debt market over last one month

Interest differential & growth exhaustion:
Interest rate differential is expected to attract additional capital flows, however risk aversion could temper the momentum. Fresh inflows would augment trouble for Central Bank in balancing exchange rate and liquidity, requiring interventions

There has been no signal in change of RBI preference for inflation containment and it maintains growth being good in India. However, RBI falls short in recognizing explicitly that slowdown is underway. Slowdown in consumer durable segment and lower index of industrial production indicates the exhaustion in growth of economy

RBI has clearly stated that policymaking is driven purely by domestic factors and is not depending on global developments. However, undertone remains cautious due to global uncertainty and possible inflationary pressures on account of global commodity and food prices

Expectation:
Developed markets are expected to under perform the emerging markets while triggering the correction in asset prices globally. Rally in precious metals appears stretched and is expected to witness corrections

Its likely that Central bank maintains a neutral policy stance and interest rates to have a downward bias. Whether RBI cuts rates in coming weeks would depend on softening of base metal and crude prices. Going ahead country is expected to have a softer interest rate regime and interest rates are expected to move downwards over coming quarters

"Soft landing, Decoupling to Re-coupling of markets, Re-pricing of risk"

Advent of New Year 2008 has started giving clear evidence of a soft landing under way for Indian economy and most of the overheating concerns appear behind us. Inflation numbers if not too benign, appear to be in comfortable range. Index of Industrial production for November grew just 5.3% as against 12%. Slower credit off take and reduced housing loans are showing the impact of repeated money tightening measures of central bank

Liquidity conditions turned comfortable as the RBI reversed the spree of unwinding bonds under the Market stabilization scheme (MSS). RBI nearly unwound Rs 18,000 crore bonds during November and December while sold nearly Rs 8,000 worth bonds in first week of January, indicating the return of easy liquidity conditions

Recent spurt in MSS indicates improvement in liquidity, which the central bank is mopping up. Though there is not a significant pick up in foreign direct investments as against the hyped anticipation for January, this time of the year, there tends to be sizeable provident fund inflow in the system

So far central bank has lapped up forex inflows worth $ 76 bn (nearly Rs 2,18,775 crore). Outstanding MSS amount to nearly Rs 1,77,838 crore against Rs 62,000 crore in April’07

Continuous release of deteriorating US economic data strengthens the expectation of US Fed rate cut. Fed futures discount nearly 1% rate cut by June’07. European and England central banks have held their rates unchanged and may see a cut in second half of the year

It has been extensively debated that emerging markets are decoupled and would sustain unabated growth. Its true that any rate cut is good news for emerging markets including India as the funds flow gets directed to them

However, the exuberance may be short lived as US goes into recession. The problem occurs not because of direct economy linkages but because of financial market linkages. As US economy goes in recession, magnitude of re-pricing would matter, as it will be unidirectional for a prolonged period

Developed markets are expected to under perform the emerging markets while triggering the correction in asset prices globally. Liquidity and risk aversion will continue to push precious metals to higher levels with intermediate corrections

Given sizeable funds targeted from Middle East (e.g. shariat fund), and expected rate cuts in US, India is expected to see huge inflows in coming weeks. This would add to the conundrum of RBI while balancing the interest and currency rates. Economic data would compel RBI to maintain a cautious stand with a softening bias leading to softening of yields