»The Honest Truth by Ajit Dayal

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.