Why RBI may cut interest rates by 1%

28 MARCH 2016

In a conversation with my colleagues who manage the fixed income portfolios for Quantum Liquid Fund and for Quantum Dynamic Bond Fund, it is clear that they believe the Reserve Bank of India will reduce interest rates by 0.25% to 0.50% (25 basis points to 50 basis points) at the next monetary policy meeting of the RBI on April 5th. And - they further informed me - that is the 'consensus' in the market.

But I was willing to challenge their 'data-driven' thought process and tossed what may the equivalent of a bouncer or a googly: "Could the RBI reduce interest rates by 100 basis points (1%) in the monetary policy meeting to be held on April 5th 2016?"

Equity investors - like me - are naturally born optimists. We tend to see growth when there is none. We tend to see 'green shoots' when there is barren, cracked land! (Of course, the good equity investors will also see the fraudulent forecast and not get carried away with false hopes!)

Bond investors tend to be pessimistic in nature. The world is coming to an end and holding government paper (or FDs with State Bank of India) which will generate a steady stream of earnings is seen as the anchor of their investment portfolios! (A word of caution: some bond investors have turned into equity investors and start buying bonds issued by third-rate companies run by third rate managements!)

Gold bugs (and I am partly in that camp) believe that the central bankers (with the sole exception of our very own Raghuram Rajan) have lost control of their minds and of monetary policy. Holding fixed income paper will not be a sensible investment given the potential of rising inflation and - equally important - the inability of many economies and governments to service their debt.


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Why a 1% cut in interest rates is possible!

So, given this frame of mind - and the skepticism that the fixed income team at Quantum Mutual Fund - I decided to go out on a limb and tell you why I think the RBI may charge ahead with a 100 bps cut!

  1. The Consumer Price Inflation has come down significantly from 11.5% in November, 2013 to 5.2% in February 2016. And, given the slowing global economic environment which has led to sharply lower prices for manufactured goods as well as for critical commodities like petroleum products, inflation is unlikely to go up in the near term. As such, inflation should be on course to stay well below the RBI target of 5% to be achieved by March 2017. In the Indian context, the spoilers for this may higher crude prices, higher food prices due to unseasonal rains, and the higher salary costs due to the Seventh Pay Commission;
  2. The current real interest rates are slightly above 2% and are at the higher end of the targeted real rate band of 1.5% to2.0% over expected CPI. The 'real interest rate' is the interest rate on, say, a 10 year government bond (7.5%) minus the inflation rate (5.2%) that we read about in the papers. So, there is room for a big cut. And, if the economy does not behave well, the RBI can always raise interest rates by 25 basis points or 50 basis points over the next 12 months.
  3. From a timing perspective, this could be the last window of opportunity for the RBI governor to deliver a boost to kick start economic activity. The June monetary policy meeting will focus on the outcome of the monsoon and may not be an appropriate time for RBI to take any action. The August meeting will be an awkward time for the RBI to take any action on interest rates since Governor Rajan's term is scheduled to end on September 5th, 2016. In case Governor Rajan is not given an extension and a new Governor is appointed, that new Governor may not be in a position to reduce interest rates: it will be too soon to take such action. In the likely event that Governor Rajan was to get the extension of his term, it may be awkward for him to announce a cut in interest rates as some may view this cut in rates as a reward for an extension! The independence of the RBI may be questioned by some and that is an extremely dangerous situation. For example, the US Central Bank (the Fed) and the European Central Bank (ECB) is no longer any sort of role model for central banking policies. They have, instead, become role models for lost teenagers keen on getting their hands on the next dosage of drugs and artificial stimulants!
  4. A 1% cut in interest rates would boost the value of the bond portfolios of banks by 10% to 15%. So, for every Rs 100,000 crore of bonds held by the banks, there will be a possible Rs 12,000 crore to Rs 15,000 crore surge in the net worth of the banks. This will help in an environment where banks have seen a large erosion of their net worth due to the acceptance of bad loans to various businesses;
  5. Probably the biggest argument I have for this wild call of this sharp 1% reduction in interest rates is of a non-monetary and non-economic nature. Arvind Subramaniam, currently the Chief Economic Advisor in Ministry of Finance, was in the IMF from 2000 till 2007. Governor Rajan was at the IMF between 2003 till 2006 as the Chief Economist. The two have worked together then. Why is it difficult to believe that they are working together now? And they are embarking Indian on a great economic journey just as a jugalbandi between Pandit Shivkumar Sharma and Pandit Zakir Hussain would enthrall us? Or a jugalbandi between Pandit Hari Prasad Chaurasia and Pandit Zakir Hussain would leave us spiritually mesmerized? Look at recent history. In September 2015, the RBI slashed interest rates by 50 bps - effectively putting the ball in the court of the Ministry of Finance to show their commitment to financial and structural reforms. The budget, presented on February 2016, has probably made the RBI happy as it has focused on improving farm incomes and focused on getting the fiscal deficit to 3.5% of GDP. Now that the Chief Economic Advisor Arvind Subramaniam has done his bit, Governor Raghuram Rajan needs to play his tune....

Bold central bank governors and fearless economists make bold moves. This monetary policy may be the last window of opportunity till September for a meaningful rate cut. With such a sharp reduction in interest rates, sentiment in India will improve. And that is badly needed given that any significant economic reforms are some time away. My bet is that an uncertain world with low growth prospects and low inflationary fears may result in a 100 bps rate cut. A call cannot be classified as 'wild' because no one has thought about it - and I hope I have made a case for a 100 basis point cut to be announced on April 5th.


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Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is Founder of Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site.

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6 Responses to "Why RBI may cut interest rates by 1%"

Prasad

Apr 1, 2016

That's not gonna happen at any cost. Raghuram Rajan is not Mario Draghi. Hope he continues for another term.

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Ameet parekh

Apr 1, 2016

Sale on Indian corporates : Jindal' selling steel rail business , Essar selling steel and oil business , GVK sold airport& power on block , DLF selling land banks , GMR assets r on sale ,JP group sold cement , power , road assets , Tata selling Corus , Lanco assets on sale , Videocon selling oil assets , Renuka selling Brazil business , Sahara assets on sale , Mallya assets on sale ..Have you heard in 60 years any Indian promoter selling their company to repay bank loan !!? Now you know who is whacking the whip ..😊🙏

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Ramarao

Mar 29, 2016

Dear Ajit,

Instead of comparing a CPI with a 10 yr G SEC, in my view one should compare it with a 91/364 day t-bill. CPI will fluctuate on a month to month or Q to Q basis and hence comparing with a 10 yr paper may not be appropriate. RBI reduced the rates by 50 bps in Sept 15 end, boosting the HY 15 end book value of G- secs held by banks. But by Dec 15 the yld were where they were before the Sept reduction and by Feb 16, the yields were far higher than where they were before the Sept 15 cut. Had the policy were in March 2016, RBI would have given a one more booster (by sharply reducing rates) to the banks balance sheets by propping the market value of g secs. Even if RBI cuts rates by say 1%, it will not help banks balance sheets as the huge borrowings from April 16 onwards will dampen the prices by Sept 16... Irrespective of what happens to the value of G secs (and banks balance sheets), lets all take out some time everyday and pray for a very good monsoon (for the welfare of mankind)..Should we have a below normal monsoon, all rate cuts benefiting banks book value of g secs etc etc will go for a toss..

What the country needs is a clean government and a clean bank management..This will automatically
bring the inflation down and consequently the interest rates..

Like (1)

Debashish

Mar 28, 2016

very well written rational logic

Like (1)

Sankar

Mar 28, 2016

Ajit,

I sincerely hope you have sent a copy of this excellent suggestion to Governor Rajan - excellent food for this thoughts! If you haven't done this already, I strongly suggest that you should do it - who knows, maybe he might be tempted to exactly this!!

Sankar

Like (1)

Rajan Ghotgalkar

Mar 28, 2016

An extremely rational presentation in support of what could be a distinct possibility i.e. RBI delivering on a 1% cut. You are right this is possibly the last window of opportunity for a monetary kick start mainly because, the oil scenario may not stay benign beyond FY 16-17.
Recommend, that, you also provide your subscribers with a similar commentary & debt market round up on a monthly basis.

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