India's benchmark policy rate is expected to be cut by at least 25 basis points on Wednesday after the six-member Monetary Policy Committee completes a two-day meeting.
The rate review, the second by the MPC, comes against the backdrop of a decision to demonetise and withdraw Rs 500 and Rs 1,000 currency notes. The resultant cash crunch is likely to impact economic activity in the near term and could pull down inflation to levels well below the Reserve Bank of India's 5 percent target for consumer price inflation by March 2017.
This, some economists, feel leaves the scope for a 50 basis point cut as well. The benchmark repo rate currently stands at 6.25 percent.
Along with the rate decision, market participants are also waiting for a view from the RBI on demonetisation. Most importantly, analysts want to know how quickly the 86 percent currency withdrawn due to demonetisation will be replaced.
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25 Bps Cut & Improved Transmission
Bank of America Merrill Lynch (BofA ML) expects the MPC to cut policy rates by 25 bps this time and in April to combat the on-going demonetisation shock. With liquidity expected to be comfortable due to the inflow of deposits, the research arm of the financial services firm expects lending rate cuts to follow.
Apart from the interest rate decision, BofA ML is looking for answers to key questions related to demonetisation. The first of these questions is – how long will remonetisation take?
We pencil in January for now. As each month of disruption costs 0.3-0.5 percent of GDP, we have cut our FY17 growth target to 6.9 percent (from 7.7 percent earlier) with fourth quarter growth slipping below 6 percent.Bank of America Merrill Lynch
The research arm of the financial services firm is also watching to see if demonetisation will lead to lower open market operations from the RBI or a special dividend to the government?
We expect the RBI to reduce OMO, if the RBI Act will allow it to write off Rs 500/Rs 1,000 notes which do not return by March 31.Bank of America Merrill Lynch
Read: Rate Cut Likely This Week; RBI May Step In To Support Growth, Say Economists
50 Bps Cut Possible But Not Likely
HDFC Bank also expects a 25 bps cut in the benchmark rate, keeping in mind both domestic and global compulsions. Such a cut, which will bring down the repo rate to 6 percent, will help support the investment cycle and counter any near-term slowdown due to demonetisation, said Abheek Barua, chief economist at HDFC Bank in a research note.
In our view, while a case for 50 bps cut in the policy rate can be made if one takes a really dire view of the impact of demonetisation, there are too many balls up in the air at this time. Apart from the impact of demonetisation on growth, global factors such as the policy regime in the U.S., an impending Fed rate hike and its impact on global bond yields and currencies, political uncertainty in the euro zone and its impact on emerging market currencies, and rising global commodity prices with recently concluded OPEC deal and expectations of a massive fiscal stimulus in the U.S. have to be factored into the policy decision.Abheek Barua, Chief Economist, HDFC Bank
HDFC Bank expects the demonetisation to have an adverse impact on GDP growth in the near-term but adds that the extent of the impact remains uncertain. It says the sudden surge in bank deposits and the dip in bond yields could lead to distortions in the money markets that have to be managed carefully.
As a result of the surge in liquidity, the benchmark 10-year bond yield has fallen to near 6.20 percent and is trading below the policy repo rate.
While the RBI has used the CRR (cash reserve ratio) and now MSS (market stabilisation scheme) bonds to manage liquidity and possible mispricing, a sharp cut in the policy rate could again create bubbles and drive kinks in the fixed income markets.Abheek Barua, Chief Economist, HDFC Bank
Read: RBI Policy Decision: A Fine Balancing Act
No Rate Cut? A Contrarian View
According to India Ratings and Research, the MPC may decide to keep rates unchanged while maintaining an accommodative stance. This would leave scope for a rate cut early next year.
Bond markets, where yields have fallen due to excess liquidity conditions and the expectation that the RBI will cut rates atleast by 25 bps, may see a sell-off if there is no rate cut.
Ind-Ra believes that a status quo policy will lead to realignment between market expectations and RBI's outlook. Additionally, weak global cues – uptick in crude oil prices, surge in global bond yields adds to the caution in the bond market environment. Ind-Ra, therefore, believes the bond markets could undergo some correction hereon, in the event that the RBI maintains a status quo on rates. That could also open up the possibility of widening of corporate bond spreads.India Ratings and Research
The rate decision will also likely impact the direction of the rupee, said India Ratings. The Indian rupee hit a record low of 68.8650 against the dollar on November 24 but has recovered since.
The currency is feeling the pulls and pressures of a number of domestic and global factors. A narrowing of the differential in U.S. and India bond yields has led to increased outflows from the domestic debt markets, putting pressure on the currency. A 25 or 50 basis point cut may worsen that scenario.
The rupee will take cues from RBI's monetary policy – as it may lead to erosion in risk appetite. Following the outcome of the Italy referendum, consequent financial and political instability is likely to keep investors preference strong for dollar assets. Additionally, there is a near consensus among market participants of a rate hike in the next week's US Fed policy review. The gains in the rupee, therefore, will be limited and reined in by the evolving risk preference.India Ratings and Research
Read: An RBI Rate Cut Is Par For The Course
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