The latest inflation data make it overwhelmingly likely that the Reserve Bank of India (RBI) will cut interest rates again, and soon at that. Short-term considerations based on the global situation could lead to some sort of a tactical delay on the part of RBI. But India's macroeconomic data now strongly indicates that a cut is likely to be beneficial and RBI is unlikely to ignore multiple signals that point in the same direction.
The Wholesale Price Index (WPI)-based inflation for August was minus 4.9 per cent down, year-on-year (y-o-y) versus the WPI for August 2014. This was the tenth month that the WPI spent in negative territory, which indicates a sustained trend. The energy WPI basket was down by over 16 per cent y-o-y. The y-o-y change of minus 4.95 is a historic low.
The Consumer Price Index (CPI)-based inflation for August was up 3.6 per cent y-o-y, which was lower than expected. The y-o-y change for the CPI also shows a falling trend since the July CPI was up 3.69 per cent. The CPI change of 3.66 per cent was a nine-month low.
There is some base effect evident since crude prices were hovering around $100 a barrel in August 2014 and crude has lost more than 50 per cent of its value since. But by September 2014, crude prices had started falling and the base effect should therefore, ease off, in subsequent data.
There are no obvious reasons for inflation to suddenly spike up at the moment. A broad consensus expects that crude prices will stay low and so will gas and coal. Globally, food commodities basket has also seen prices trading down, even though there are some signs of a rise in domestic food prices. Again, food prices seem to be under control despite a poor monsoon. There are no real fears that either the energy or food components will suddenly jump in price.
At the same time, bank credit growth is extremely low -as low as it's been in 20 years. Corporate earnings have been flat since Q2, 2014-15 (July-Sep 2014). While RBI has cut policy rates thrice, banks have not cut their rates sufficiently to pass through the effect.
Corporates with healthy balance sheets have tapped overseas debt, or floated corporate bonds in Indian markets, in preference to bank loans. This is because healthy corporates can access funds at far cheaper costs via these routes, compared to going commercial bank rates.
Banks, especially PSU banks, are also struggling to cope with the burden of a large volume of non-performing assets (NPAs). One way to reduce the impact of NPAs and restructured corporate debt is simply for bank credit to grow quickly enough.
A rate cut would stimulate business activity and help banks grow credit volumes, assuming that the banks can pass it on. There is little chance of it causing an inflationary impact. So it may fuel a new cycle of corporate investment. A rate cut could also potentially, nudge the rupee down. That would be a good thing, given the collapse of Indian exports. In theory, if rupee rates are cut, the currency should also fall since rupee debt returns will drop. In practice, of course, a rate cut may also promptly lead to increased overseas investment inflows (both FDI and portfolio), and the rupee might actually appreciate.
However, beyond a point, the impact on currency is a secondary consideration. Given that growth is slow, inflation is low and banks are struggling to generate credit volumes, the classic prescription is a rate cut. RBI has set an inflation target of below six per cent by January 2016 and that will easily be met.
Rate cuts, therefore, now boil down to a matter of timing. Banks and other financial sector stocks are likely to see a fair amount of speculation until such time, as there is actually a rate cut. RBI is also unlikely to stop at just one rate cut.
If it does start cutting, it is very likely to push rates down over most of the next year. That could have profound effects on the bond and equity markets, once banks do start transmitting those policy rate cuts through to their corporate clients.
Based on this logic, banks and other financial sector stocks, including housing finance majors, specialist infrastructure finance organisations, etc., could be a focus area for both positional traders and long-term investors. There is also likely to be interest developing in debt funds, once the cycle of rate cuts resumes.
