First RBI rate cut in 3 years unlikely to cheer market

In a poll, 17 of 20 analysts forecast a 25 basis point cut in the policy repo rate next week

The Reserve Bank of India is expected to cut interest rates for the first time in three years on Tuesday, but investors will be pleased only if there is an accompanying cut in banks' reserve requirements and a dialing-down of policymakers' hawkish tone.

In a poll this week, 17 of 20 analysts forecast a 25 basis point cut in the policy repo rate next week, which would bring it to 8.25%. A minority expected a cut in the cash reserve ratio (CRR).

"The disappointment would be huge (if there is no policy rate cut)," said Abheek Barua, chief economist at HDFC Bank in New Delhi.

However, economists have scaled back expectations for rate cuts in India for the rest of the year following last month's release of the federal budget, which did little to allay worries about the government's ability to cut its current account and fiscal deficits.

At its mid-quarter review a day before the budget, the Reserve Bank of India left rates on hold and surprised with hawkish comments, disappointing investors who had hoped it would finally begin cutting rates to boost sagging growth.

Morgan Stanley this week rolled back its rate cut forecast and now expects the RBI to leave rates on hold on Tuesday, citing a wide current account deficit, a loan to deposit ratio at an all-time high of 78.1% and stubbornly high inflation.

Instead, it expects the RBI to cut CRR once again to address a persistent shortfall in banking system liquidity, which would also help reduce borrowing costs. The RBI has cut CRR by a total of 125 bps since January, effectively pumping 800 billion rupees into the system.

Still, bond yields remain high amid a flurry of borrowing by the deficit-strapped government and tight cash conditions. The benchmark 10-year bond hit a three-month peak of 8.63% in late March, easing to 8.55% on Wednesday.

Morgan Stanley economist Chetan Ahya wrote that five years of expansionary fiscal policy has been accompanied by a decline in private investment as a%age of GDP.

"We see aggregate demand pressures from the less productive government spending keeping upside risks to inflation alive," he wrote.

Wholesale price index (WPI) inflation edged up for the first time in five months in February to 6.95%. March WPI data will be released on Monday and is forecast at 6.70%, according to a Reuters poll.

Reviving growth

With New Delhi unable to rein in a fiscal deficit that ballooned to 5.9% of GDP in the year that ended in March, from its target of 4.6%, RBI Chairman Duvvuri Subbarao was left with the grim task of managing inflation And tightening monetary policy long after other countries had begun to ease rates in the face of slowing growth.

Those high interest rates, combined with sullen corporate sentiment resulting from a lack of pro-growth reforms and a slowdown in project approvals, have battered growth and hit capital spending.

India's economy grew just 6.1% in the December quarter, its slowest in nearly three years.

Fixed capital formation contracted by 4% in the September quarter and 1.2% in the December quarter, the first consecutive declines since the government began tracking it by quarter in 1996, Credit Suisse said in a report this week.

Adding to evidence that the economy is losing momentum, industrial output grew a much-slower-than-expected 4.1% year-on-year in February, figures released on Thursday showed, though the data series is notoriously volatile.

Credit Suisse economist Robert Prior-Wandesforde said it is now up the RBI to stimulate growth, and expects a total of 175 basis points of rate cuts by March 2013, a position that makes him an outlier, with most economists expecting more modest cuts.

"RBI rate cuts are the only credible trigger for improved investment," Prior-Wandesforde said by phone from Singapore.

"They can't just carry on waiting for the government to do the right thing," he said.

The RBI's priority, however, remains fighting inflation, where the outlook is hazy.

While inflation is far off its double-digit peaks, India remains exposed to spikes in global commodity prices, especially oil, and shortfalls in domestic food production, none of which the RBI can control.

New Delhi has been unwilling to fully pass along the rise in global crude prices to consumers, despite its long-stated intention to free up diesel prices. India will have to reckon with those pent-up inflationary pressures if oil prices continue to rise and the government can no longer bear the subsidy burden.

"Between the March policy and now, nothing much has changed apart from the only positives that oil prices are stable around $120 and metal prices have not risen," Manish Wadhawan, managing director and head of interest rates at HSBC India.

"If RBI delivers both rate and CRR cuts, it could have some positive impact and the 10-year bond can fall to 8.35%. But the momentum is unlikely to be sustained," due to heavy government borrowing, he said.