Mr. Arvind Chari

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..

• With the hike in fuel and electricity prices, the inflation trajectory going forward would have very little suppressed inflation.  So although, headline inflation would rise above 8% from November (mostly on food price base effect), the RBI would have a clear sense of the underlying trend and would still be on track for its 7.5% March 2013 target. Barring oil led inflationary shock; RBI should be incrementally supportive towards growth than inflation.
• With loan / deposit ratios realigning on lower credit off-take demand for bonds from domestic banks remains strong and acts as a good demand buffer
• Although liquidity situation is extremely comfortable and the cut in CRR further pushes out the RBI OMOs, we still factor in OMOs from November to neutralize the currency leakages. The OMO would also buffer the excess supply on the probable slippage in fiscal deficit
• We expect a 0.5% slippage in the fiscal deficit from the stated number of 5.1%; which can be absorbed by the market in terms of excess borrowing. And on that

• we expect the excess supply to be announced only in December, post the mid-year fiscal review and not in September as the markets expect
• The government has higher space in t-bill issuance and can carry out the entire slippage without any additional longer dated bond issuance
• Dis-investment getting back on track and higher than expected telecom auction flows can lead to higher comfort on the fiscal accounts.

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.

• Downgrade threat subsides: One of the major worries for the finance minister was the looming threat of the sovereign downgrade. With the action on fuel prices, FDI announcements, restructuring power sector debt, movement on dis-investments and other steps we believe that the threat of a rating downgrade is now over. This should reduce the risk premium for Indian assets
• GAAR postponed / indirect transfers to be watered down: Another factoring impact investment sentiment was the taxation changes as proposed in the Budget. We hold that as the single biggest reason for the rupee to have gone below its December lows of 54.30. Now, with the amendments being rolled back, investor sentiment should change for the positive.
• Negative rhetoric but flow activity strong; lower hedging should lead to rupee appreciation: Despite all the negative news flow, the Indian equity markets have got continued inflows and are among the best performers but the rupee has lagged. As confidence in the economy builds up further, we would see inflows with lower hedging demand which could lead to higher rupee appreciation. These inflows also indicate that investors are finding problems in other countries also and if India gets its act together, we should be the recipient of a larger share of emerging market flows.
• Likely removal of withholding tax on domestic infra bonds will be another positive for rupee flows

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.

• Implementation of GST and a modified Direct Taxes code is a bigger reform and would pave way for a faster adjustment in fiscal accounts. We expect some announcement in the next year's budget
• Power sector draws big investments and it is in everyone's interest to sort out the issue at the fuel supply (coal) and distribution. The restructuring package for the losses at the distribution sector is likely to be announced in the next week. If managed well and on the back of tariff hikes, we would see higher comfort across the chain (government, private sector, lending banks, and bond holders) in allocating capital to the power sector. Dealing with the coal mining issue in a transparent manner can also lead to further confidence amongst investors.
• A credible medium term fiscal consolidation plan
• Key events to watch - Upcoming telecom auctions; Dis-investments 

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.