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Event update: Economy - RBI cuts rate on expected lines; shift in focus to transmission and boosting demand

The shift in the policy stance and 75bp cumulative rate cuts has brought down real policy rate to around 1% (repo rate of 5.75% and 3-month average core inflation of 4.7%), which is fairly accommodative for an expected 7% real GDP growth. RBI’s effort would be to ensure better transmission of rates cuts already announced. With the focus shifting towards the fiscal stimulus from the upcoming budget, along with an accommodative monetary policy, in our view, should boost consumption demand. We believe, it is unlikely that private capex will revive immediately even with better rate transmission.

Rate easing in response to weakening growth

The 25bp repo rate cut by RBI along with change in policy stance to accommodative was in line with market expectation. Repo rate now stands at 5.75%, after three rate cuts from its recent peak of 6.5%. The changed stance and rate cut are aligned to the recent sharp weakening in real GDP growth decelerating to 5.8% in Q4FY19. This is demonstrated in a sharp decline in capital formation growth and moderation in consumption demand, especially in rural areas.

Growth to improve in H2FY20E

RBI has scaled down its FY20E GDP growth forecast to 7% from 7.2% earlier, to accommodate lower H1FY20 growth expectation of 6.4-6.7% from 6.8-7.1%. The H2 median growth remains unchanged at 7.4%. Hence, the downside surprise in growth is seen as transient with mid-point growth rising from 6.6% in H1FY20 to 7.4% in H2FY20 or an upside of 160bp from the low of 5.8% in Q4FY19.

Unchanged inflation trajectory

However, RBI has maintained its inflation projections at 3.0-3.1% for H1FY20E and 3.4-3.7% for H2FY20E. The easing inflation is seen as a spill over effect of the deceleration in growth in the near term. Upside risk to inflation emanates from global fuel prices and its pass-through effects, financial volatility and expansionary fiscal policy. Overall, the context of GDP growth recovery from 5.8% in Q4FY19 to 6.6% in H1FY20 and finally to 7.4% (mid-point) in H2FY20 along with unchanged inflation projections implies that the central bank is expecting reasonable improvement in demand conditions.

Gsec yields drop further to price in further rate cuts, even as equities correct from high valuations

From the market standpoint, Gsec yields have moderated further with the 10-year Gsec yield softening ~10bp since 5 June 2019 close of 7%. Bank stocks tumbled post the policy announcement, with even higher correction seen in private banks. The lack of support for the NBFC sector that the market was expecting has also resulted in deep stock price correction in housing finance companies and banks having exposures in them.

Outlook - Focus shifting to rate transmission from rate easing

The shift in the policy stance and 75bp cumulative rate cuts has brought down real policy rate to around 1% (repo rate of 5.75% and 3-month average core inflation of 4.7%), which is fairly accommodative for an expected 7% real GDP growth.

RBI’s effort would be to ensure better transmission of rates cuts already announced. As of now, the past two rate cuts of cumulative 50bp have seen a transmission of just 21bp (as indicated by weighted average lending rate on fresh rupee loans). Hence, we think the central bank will rely more on liquidity measures to facilitate transmission than follow up with additional cuts immediately.

With the focus shifting towards the fiscal stimulus from the upcoming budget, along with an accommodative monetary policy, in our view, should boost consumption demand, by aiding higher retail lending, especially for things like durables and autos. We believe, it is unlikely that private capex will revive immediately even with better rate transmission.

Further reduction in rate would be a function of negative growth surprises, compared to RBI’s projections. Such as scenario can arise, if re-emergence of global trade conflicts intensifies to create severe growth deceleration. Negative surprise on rates can arise from sustained rise in food inflation.