Raghuram Rajans last interest rate action has taken a lot of people by surprise. The jury is still out on whether the rate cut 40 days before the scheduled policy and at a time when the Union Budget was inflationary in general was called for.
As I seen things the main reason for the cut seems to be the fact that RBI now believes that the slow pace of the economy is unlikely to lead to a pickup in inflationary pressures in the near term. Moreover low global commodity prices are assumed to be here for a medium to long term. Although Rajan did speak about the quality of Fiscal Consolidation the logic for the same is just not there. In my personal opinion more money in the hands of States is more inflationary as States tend to be more profligate than the Centre. The other concern in the back of the mind of Rajan seems to be the strength of the INR. Since August last year the movement in EM currencies has been as follows
Brazil Real – down 30%
Turkish Lira- 20%
Besides this developed market currencies like Euro and JPY have also depreciated significantly against the INR. This is impacting our export competitiveness in a big way and lower rate differentials might lead to some fall in the value of the INR.
Now when I say that Rajan needs to cut on 7th April I am following his own logic where he believes that the economy is in slowdown, there is excess capacity and there is need to front load the impetus given to the economy. NPA strapped banks have refused to pass on the rate cuts to borrowers. However come April and improved liquidity we should see rate cuts percolate down.
In order to make monetary policy more effective now RBI need to cut again on 7th April. This will push a nearly 50 basis point cut into the economy at one shot. This will have a twofold impact.
- It will improve the balance sheets of debt laden corporate and improve their debt servicing ability. There are a large number of companies that have good operational performance, however tight liquidity and high interest rates have impacted their performance. These companies will see an immediate improvement in their profitability.
- It will make lot of new projects and investments more viable as rates come down by nearly half a percentage points. It will give a definite impetus to capital formation all across. Right from infrastructure to corporate capex as well as demand for housing loans, home sales etc.
The other strategy that RBI can follow if it actually wants rates to move down is to improve liquidity by OMO’s where it buys government bonds from the markets and releases liquidity. This will have an immediate impact of bringing market rates down. However it does not seem to be inclined to do so right now.
RBI’s thinking seems to be that core inflation is well under control and unlikely to come up in the near term. Fuel inflation will also remain subdued although food is another matter given the fact that seasonal reduction in prices has been lower this time and summers could see some sort of spike.
In conclusion the time for half baked measures is over in my view. Either RBI needs to follow its own logic and drive rates down enough so that it leads to a real improvement in economic performance or else its recent measures might come to nought. It needs to front load and then it can give itself a 4 to 6 month break before responding further to incoming data at that stage.
Markets seem to have got all the positive news it was looking for in the near term. The corrective move that has started can be sharp and swift. It will provide the base for a stronger move later in the year. PSU Financials as well as Technology stocks look most vulnerable at this stage. A decent sized correction will give good opportunities to pick up stocks in a year which is likely to be a stock pickers market.