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Economy update: An unconventional rate cut in a bid to support growth

RBI cuts repo rate by 35bp, maintains accommodative stance: RBI has cut repo rate by an unconventional 35bp as MPC concluded its latest meeting (Aug-19). As per governor, MPC has taken a middle path - as 25bp cut would have been too low and 50bp cut would have been too high - thus leading to an unconventional rate cut. He also mentioned that RBI’s focus is closing the negative output gap at the moment and current rate easing cycle is targeted at supporting that.

RBI downgrades growth estimates with more downside risks: While RBI has broadly maintained inflation projections (at 3.1% for H1FY20 and ~3.6% for H2FY20), there has been a downgrade in FY20 GDP projection (to 6.9% from 7% earlier). The downgrade in growth forecast has been driven by weakness in high frequency data, muted demand conditions and weak investment activity. H1FY20 growth forecast has come down to 5.8-6.6% from ~6.5% earlier, while H2FY20 growth expectations have remained same. RBI expects H2 activity to find support from monetary easing that has been affected February onwards.

Regulatory changes: RBI announced few key regulatory changes pertaining to lenders, which are discussed below:

• Reduction in risk weights for retail loans (ex-credit cards) to 100% from 125% earlier: This is would mean higher capital availability for retail lending – positive for retail banks (HDFC bank) and leveraged discretionary consumption
• Single NBFC counterparty exposure limit raised to 20% of tier I capital against 15% earlier and NBFCs lending to priority sectors (Agriculture and MSMEs) can be counted by banks under their own priority sector lending requirement: These two measures will add to banks’ capacity lend incrementally to NBFCs. We believe that benefit of this regulation will depend on individual NBFCs and their balance sheet strength & relationship with lenders and may inturn benefit strong NBFCs. Our banking team highlights Shriram transport finance, HDFC, LICHF and CanFin as possible beneficiaries.

Outlook: The assessment of the MPC is that the economy has been undergoing slowdown based on recent global developments, however some of the domestic indicators as per RBI, are signaling improvement (air passenger traffic growth, PMIs). RBIs expectation of impact of already underway monetary stimulus reflects in 7.3-7.5% real GDP growth expectations in H2 after 5.8-6.6% in H1. Rate cut action of 35bp easing reflects a well calibrated move which encompasses prospective transmission of earlier rate easing since Feb’19 and addition 35bp to adjust for the current impulses. These essentially are being seen as preemptive moves, for prospective support for the demand boost. So in a way the RBI is limiting the expectation of further rate cuts any time soon. In our view, the focus will now shift on to rate transmission. We maintain our view that it will require fiscal spending to support discretionary spending. Since the markets had priced in more cuts, there has been a correction in rate sensitive stocks, especially in the BFSI space. We also believe that with RBI may take a pause here and there will be a continuing depreciation bias in INR. Hence, G-Sec May harden from here. The key risk to this call will be lack of revival in credit growth in H2. As of now, despite the decline in non-food credit growth to 12% in H1, the credit to deposit ratio is still high at 77%. H2 typically sees higher credit demand and there is a possibility of a further higher CD ratio. However, we also consider the trajectory of core inflation which currently is at 4.15% and considering a desirable real rate of 1.5-2%, we arrive at a neural rate of 6.15-5.85%. Consequently we believe that current rate is on the accommodative side. This overall builds a ground supporting our earlier G-Sec yield view of 10 year yields reverting back to ~7% levels (details ).