Why will RBI go for a rate cut in its July review

Investors looking to lengthen maturity of their fixed income portfolios should use the opportunity provided by the higher than expected April inflation numbers to build up their portfolios.

India has had a relatively weak start in fiscal 2012-13 with broad macro indicators suggesting a slowdown in the economy. IIP (Index of Industrial Production) growth was negative for the last month of fiscal 2011-12 with growth at a negative 3.5% against a growth rate of 4.1% seen in February 2012. Manufacturing growth was a negative 4.4% for March against a growth rate of 4% for February. IIP growth for 2011-12 stood at 2.8% against 8.2% growth seen in fiscal 2010-11. IIP trends indicate weakness in the economy even though the numbers are seen as suspect due to its volatility.

Trade data for April 2012 showed a 14.6% fall in exports and 11.8% fall in imports on a month on month basis. Trade deficit was down by 6.3% month on month. Vehicle sales showed a growth of 10% on a year on year basis with passenger cars and commercial vehicles growing at below 5% levels. One month of data does not suggest broad trends for the year and May data will be watched for confirmation of weak trends.

Inflation for the month of April 2012 came in at 7.25% against levels of 6.89% seen in March 2012 and against market expectations of 8.7%. Inflation should ideally come off due to domestic and global economic weakness and falling oil prices but the sharp drop in Rupee by over 20% from highs seen in 2011 is pushing up cost of imported goods leading to inflation remaining sticky.

RBI had cut the benchmark policy rate the repo rate by 50bps in April 2012 and the central bank had indicated that further rate cuts would depend on many factors including trajectory of inflation and economic growth. RBI is also busy fighting a weakening Rupee, which is trending towards record, lows of Rs 54 to the USD, and its intervention in the currency markets is forcing it to add liquidity into the system through government bond purchases. RBI has bought around Rs 25,000 crores of government bonds since April 2012 to add liquidity into the system.

RBI's bond purchases is seen as a quasi monetary easing as bond purchases add primary liquidity into the system. Hence the central bank may wait for further conformation of economic weakness before reducing policy rates in June 2012, unless the May data is extremely weak warranting an emergency rate cut. 

Government bond yields will stay at current levels of 8.55% on the ten year benchmark government bond on the back of continuous weekly bond supply, tight liquidity conditions and no rate expectations for June. The government is auctioning Rs 15,000 crores of bonds on a weekly basis while liquidity is negative with banks borrowing over Rs 100,000 crores from the RBI on a daily basis. Liquidity is expected to tighten in June due to first quarter advance tax payments. The higher than expected inflation for April 2012 will drive out any rate cut expectations in RBI's June policy review. 

Bond yields will trend down post RBI policy review in June as liquidity situation will ease on the back of advance tax money coming back into the system while the country will have seen the onset of monsoons. Rate cut expectations will gain momentum for July as inflation is likely to keep its head down on weak commodity prices.

Global central bank rate actions suggest sustained weakness in commodity prices.   Australia and Brazil cut policy rates in May 2012 and April  2012 respectively to shore up their economies that are threatened by falling growth expectations while inflation is not seen as a big threat due to fall in commodity prices. Commodity prices as measured by the Reuters CRB commodity index, are down over 17% on a year on year basis. China cut reserve requirements for banks in May to add liquidity into the system in order to shore up consumer demand. China's inflation for April came in at 3.4% against 3.6% levels seen in March. China's industrial production growth for April was at 9.3% on a year on year basis against a growth rate of 11.9% seen in March. China's GDP growth at 8.1% for the first quarter of 2012 is a three year low.

- Arjun Parthasarathy

The author is the Editor of  www.investorsareidiots.com a web site for investors.