RBI may cut rates in Feb, feel Morgan Stanley, YES Bank

Ahya sees September quarter GDP at 5.1-5.2 percent, and at 5.7 percent for the full year. And while crude prices have been sliding and fallen to around USD 72 per barrel, Ahya expects it to stabilize around USD 85 per barrel over the next 6-12 months.

Below is the edited transcript of Chetan Ahya and Shubhada Rao's interview:

Q: How are you drawing the inflation trajectory from hereon? What is the in-house Morgan Stanley view of the trajectory of crude prices over the next one year and separately what is your trajectory of inflation over the next 12 months?

Ahya: For crude, it’s a bit more of an evolving situation. The expectation was that the Organisation of Petroleum Exporting Countries (OPEC) will meet and decide to take some production cut but since the way the outcome has come out, it looks like it is more favourable for the oil prices and so in that sense, oil prices are surprising us on the downside, which is good news for India of course but from the oil commodity price perspective, it is downside forecast.

In terms of inflation, we are expecting it to hit to 4.5 percent in November 2014 first and then as base effect recedes, it is expected to rise back again in Q1 but the key number that RBI is looking at is when does inflation transition to 6 percent sustainably and we think that period is April 2015, which is well ahead of January 2016 that RBI had put itself as the comfort timeframe.

Q: Your trajectory?

Rao: For FY16, if oil does settle somewhere even if at a conservative level of USD 85 per barrel, we could see a consumer price index (CPI) averaging at 6 percent in the next fiscal year. If of course oil trends even lower than that on an average level at USD 80 per barrel, we could see about 5.8-5.9 average CPI for the next year, which to my mind is a great, huge positive. From a peak of USD 115 per barrel, we have seen 38 percent cut, let us not forget RBI had assumed USD 100 per barrel which now stands somewhere close to around USD 72.50 per barrel. Of course we need to see at what level it eventually settles, but broader consensus, I would believe, would emerge somewhere between USD 75 per barrel give or take USD 2 per barrel.

So overall, I think oil is definitely providing the biggest comfort both to the government and importantly as the situation evolves, also to the RBI.

Q: Can you tell us what the math looks like now given that we have seen a fall of about 35 percent in crude in the last six months, how much will the import bill go down by?

Ahya: The sensitivity to oil prices is roughly 0.5 percent of GDP for every USD 10 per barrel change in oil prices so essentially that is the impact on the balance of payment (BoP). In terms of the implications on oil subsidy, honestly now we have reached a stage of oil prices where the subsidy has already become zero. It is not likely to be positive as long as the prices pass through but now it has almost become irrelevant for oil subsidy perspective, so it is really BoP that is 0.5 percent of GDP.

Q: Now to the December 2 expectation. Your average to the next year is 5.8-5.9 percent but the November number at 4.5 percent is also not sustainable. What is the governor doing on December 2, when are you expecting the first rate cut and how much over a 12 months period?

Rao: I would think that taking in significant levels of oil at these USD 72.50-80 per barrel if they settle around that, I think RBI would probably also consider a February rate cut. While until two days ago, we were putting as an outside chance for February rate cut but the probability over the last two-three days seems to have increased.

Our base case scenario was of April being the first rate cut of 25 bps followed by another 25 bps somewhere close to the end of Q2, so overall we were pencilling in about 50 bps cut in the policy rates over the next 12 months however we believe that the oil prices if they continue to remain at these levels, we probably could see the rate cuts being brought ahead sometime in February. So if we look at growth somewhere settling around 5.4 that is our own estimate for the current year, have inflation trending significantly lower as indicated by the RBI, I would think that evolving situations would be more supportive of an earlier rate cut than before. Of course RBI is not expected to be triggered happy and instantly announce a rate cut on December 2, I think the situation would be watched as to where eventually the oil seems to settle but the OPEC meeting of yesterday seems to have formalised the speculative observation that oil is trending at multi-year low and this to my mind should begin to provide some comfort to the RBI.

Q: How many cuts you think in the next 12 months?

Rao: We are looking at two rate cuts of 25 bps each but with some small upside risk as well.

Q: What is the expectation as far as growth is concerned, what is the number that you are expecting later today and on an average in 2015, what are you pencilling in for GDP?

Ahya: We are at 5.1 percent to 5.2 percent for the number that is going to be announced today and for the financial year, we are maintaining it that 5.7 percent for March 2015.

Q: Just to continue with the credit policy and the interest rate cuts, what are your expectations, when and how many?

Ahya: We are expecting the first rate cut to happen in February and for this forecast we have made even before the OPEC meeting and we have assumed USD 85-90 per barrel for oil price. So we think even if oil prices rises back to those levels, the first rate cut should probably happen in February and we are effectively just following the framework that the RBI has led down. RBI has basically mentioned that as long as they can see 6 percent inflation visibly, which we think would be possible to see by February and as mentioned earlier, we are seeing that transition to happen from April, so as long as that is visible, it should be possible for them to make the first rate cut in February. Cumulatively we are forecasting 50 bps as well but we are also highlighting the bull case scenario, which we have assigned a significant probability of 30 percent and said that it is possible that we could transition to 5 percent sustainably from June 2015.

In that scenario, if that pans out, which is now possible with oil going lower and by the time we reach June, we would have known whether oil is sustainably staying lower or not that would potentially open up the door to do 100 bps instead of 50 bps during calendar year 2015.

Q: One tends to have a facile assumption that when crude prices fall by 35-40 percent inflation will fall hugely in India. That will lead to a logical conclusion that you can outsource monetary policy making to the Middle East. If you can just detail for us exactly how crude prices impact the CPI calculation?

Rao: For every USD 10 cut in crude oil prices we are seeing a 25 basis points direct impact on the CPI. On the Wholesale Price Index (WPI) it is a larger impact, 40-50 basis points immediately. So we are looking at a WPI number for instance for December close to one percent, a tad over one percent. So every assumption of a USD 10 cut in crude oil price is going to have a direct cut in the CPI forecast by about 20-25 basis points.

So we have seen about from 100 to 75, so 25. So, we clearly see about 45-50 basis points cut in the CPI forecast and as I said we were looking somewhere close to the average of FY16 close to about 6 percent and if crude settles around 80 rather below 85 we could even see it averaging at 5.8. That is well visible within the RBI’s fan chart and more importantly I would think that if the monetary policy framework indeed is going to formalise it somewhere early in December we would be probably looking at a scenario where the medium term target of CPI could get fixed somewhere not at 4 or 6 but in between because the governor in a couple of occasions had articulated about 4 percent being inflation of industrialised nations. So, keeping that in mind 5 percent is something that we could see that the monetary policy committee could arrive at in terms of medium term inflation.

We have seen studies by the RBI, we ourselves have done in house studies on the tolerable level of inflation at a level point where which you see a drop in growth and that somewhere would stand on long term basis around 6 percent.

Q: Where is the ten year, say in April and one year down the line?

Ahya: I don’t make revenue forecasts.

Q: Two numbers from you, the yield production and your GDP numbers as well?

Rao: We are looking at settling yield at about 8 percent by March. We are looking at about 7.3-7.5 into the next 12 months, i.e. 12 months later. As far as GDP is concerned this second quarter GDP we are pegging at 5.2, slightly higher than consensus. We are at about 2.5 on agriculture industry at 2.7 that includes of course the construction component and services steady at 6.8 percent.

So, altogether agriculture would see some cut, industry is predominantly being correcting because of flattish manufacturing though electricity has given a significant support but service is tad sideways. We are seeing good traction in trade, hotels, transport, and communications. We have seen similar move in the finance component also, but government we could see close to about 9.5 percent. Base effect will be more favourable for the government services this time around.

Q: What is your team at Morgan Stanley forecasting in terms of an average for Brent in the next 6-8 months?

Ahya: Right now, we are forecasting about USD 85 dollars average for 2015. So that is the sort of expectation that we have but as I mentioned earlier things have been changing in the way we had expected OPEC to react, the reaction has been positive surprise for us from macro perspective but negative for oil. So that is the way I would summarise our outlook.