But it did not entirely disappoint, as it cut the CRR (Cash reserve ratio - amount banks hold with RBI as a % of net deposits) by 25 bps to 4.5% (a low level seen only once before in 2003).
The CRR cut would infuse Rs 170 bln into the system and reinforces our view that the RBI would continue to support the markets through easy liquidity till the time inflation concerns keep it from cutting the repo rate. Although the clamors for rate cuts are high and it has a direct sentiment impact, a comfortable liquidity situation this year has resulted in significant fall in market interest rates and thus cost of funds for banks.
The liquidity deficit has fallen from a peak of Rs 2 trillion in Nov 2011 to a more comfortable current Rs 0.5 trillion on the back of OMOs (Open Market Operations) and CRR cuts. The easing of liquidity and cut in CRR would help banks reduce the base lending rates in line with the reduction in cost of funds. For the banking system, a cut in CRR is far more favorable than cut in the repo rate and it was no wonder that bank stocks rallied quite significantly today post the announcement. We expect RBI to proactively manage liquidity in the months ahead through OMOs which would be supportive for the bond market and short term rates.
Bond Markets disappointed
Market activity in the morning (pre-announcement) indicated that the market was expecting a repo rate cut by the RBI. The 10 year yield traded below 8.12% but it was short lived as the status quo announcement led to traders selling and it closed at 8.18%. Bond yields can inch up higher but we believe that would be an opportunity to add to build long duration positions..
RBI acknowledges government's actions
As inflationary tendencies have persisted, the primary focus of monetary policy remains the containment of inflation and anchoring of inflation expectations. In this context, the Government's recent actions have paved the way for a more favorable growth-inflation dynamic by initiating a shift in expenditure away from consumption (subsidies) and towards investment (including through FDI). Of course, several challenges remain, one of which is persistent inflation. But, as policy actions to stimulate growth materialize, monetary policy will reinforce the positive impact of these actions while maintaining its focus on inflation management. Only this will ensure that the economy derives the maximum benefit from the recent, and anticipated, fiscal and supply-side policy measures.
The highlighted sentence points to us of an indication of a likely rate cut by the RBI in its October mid-year review. If the government follows up with some more fiscal consolidation measures in that period, we would expect some policy action by the RBI in its October 30th review.
Government Reforms - biggest beneficiary would be the INR
We have always believed that hiking diesel prices and selling government stakes is no reform. They are just part of the natural adjustment fiscal process but given that the government has announced it, it is a definite positive impact. What these reform announcement would do most is to lower the risk premium associated with Indian investments and thus with the Indian rupee. We have seen the Rupee move up (appreciate) sharply in the last 2 days, sustaining it could be difficult unless followed by positive news flows in the coming days.
Big Bang reforms not needed; need smaller calibrated steps
FDI in retail/aviation is not going to bring growth back to track but some more steps towards fiscal adjustment/ consolidation should pave way for better growth mix. We would also like to see smaller steps being carried out to further strengthen the reform movement.
We still have lot of risks to worry about. Oil prices and the Euro debt deleveraging will continue to keep Indian assets edgy. But those are external and sometimes unknown event outcomes. Managing domestic inflation expectations and curtailing the fiscal deficit should be top priority. The government and policy makers should continue to work on lowering the uncertainty around domestic events.