Rajan Surprises With A Hike, Rupee At Resistance

Against our view and market expectations, the Reserve Bank of India (RBI), under the new leadership of Governor Raghuram Rajan, surprised with a 25 basis point (bps) hike in its mid-quarter review of monetary policy presented today. Effective immediately, the benchmark repo rate now stands at 7.50%, while the cash reserve ratio (CRR) remains unchanged at 4.00%. Headline wholesale price inflation (WPI) has accelerated of late, coming in at a six-month high of 6.1% year-on-year (y-o-y) in June, with the RBI citing the need to bring inflation down to more tolerable levels as the primary reason for this widely unexpected rate hike. That said, the central bank did rein in some of its earlier tightening measures in view of a more stable external environment, lowering the marginal standing facility (MSF) rate by 75bps to 9.50% and the minimum daily maintenance of CRR to 95% from 99%.

Inflation Not A Major Concern

While the RBI's latest move have caught us off guard, we do not share the Bank's concerns with regards to the inflation outlook, which for us remains relatively benign despite the recent upturn in the headline rate. Indeed, we highlight that core (manufactured products) inflation actually plunged to a fresh multi-year low of 1.9% y-o-y in August despite the uptick in the headline rate. Crucially, monetary expansion in India continues to slow, with commercial credit growth remaining weak ( see chart). Furthermore, the strong summer monsoon so far should help to keep a lid on food price inflation, which has been the largest driver in the recent acceleration of inflation. Therefore, we believe that the recent hardening of WPI will prove transitory. With this in mind, we are keeping to our end-FY2013/14 (April-March) repo rate forecast of 7.25%, which implies a resumption of dovish policy by the end of the year once headline inflationary concerns subside and anxieties over growth rise to the surface.

Benign Monetary Conditions
India - Commercial Credit & Money Supply, % chg y-o-y

Against our view and market expectations, the Reserve Bank of India (RBI), under the new leadership of Governor Raghuram Rajan, surprised with a 25 basis point (bps) hike in its mid-quarter review of monetary policy presented today. Effective immediately, the benchmark repo rate now stands at 7.50%, while the cash reserve ratio (CRR) remains unchanged at 4.00%. Headline wholesale price inflation (WPI) has accelerated of late, coming in at a six-month high of 6.1% year-on-year (y-o-y) in June, with the RBI citing the need to bring inflation down to more tolerable levels as the primary reason for this widely unexpected rate hike. That said, the central bank did rein in some of its earlier tightening measures in view of a more stable external environment, lowering the marginal standing facility (MSF) rate by 75bps to 9.50% and the minimum daily maintenance of CRR to 95% from 99%.

Benign Monetary Conditions
India - Commercial Credit & Money Supply, % chg y-o-y

Inflation Not A Major Concern

While the RBI's latest move have caught us off guard, we do not share the Bank's concerns with regards to the inflation outlook, which for us remains relatively benign despite the recent upturn in the headline rate. Indeed, we highlight that core (manufactured products) inflation actually plunged to a fresh multi-year low of 1.9% y-o-y in August despite the uptick in the headline rate. Crucially, monetary expansion in India continues to slow, with commercial credit growth remaining weak ( see chart). Furthermore, the strong summer monsoon so far should help to keep a lid on food price inflation, which has been the largest driver in the recent acceleration of inflation. Therefore, we believe that the recent hardening of WPI will prove transitory. With this in mind, we are keeping to our end-FY2013/14 (April-March) repo rate forecast of 7.25%, which implies a resumption of dovish policy by the end of the year once headline inflationary concerns subside and anxieties over growth rise to the surface.

Testing Key Resistance
India - Exchange Rate, INR/US$

Tighter Policy To Further Support Rupee

The unanticipated hike certainly sent shockwaves to the markets, with the rupee falling by just over 1% and the benchmark Sensex sinking by around 3% once the announcement was made. Similarly, Indian fixed income assets have sold off, with the interest on the 1-year overnight indexed swap (OIS) rising by approximately 15bps. Focusing our attention on the counterintuitive knee-jerk reaction of the rupee to a hike in interest rates, we are choosing not to read too much into today's moves as the day's weakness can be attributed to the unit hitting and respecting key short-term resistance following yesterday's strong gap higher ( see chart). We are keeping to our constructive outlook on the rupee, with the fundamentals backing the currency now stronger following this latest repo rate hike.

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This article is tagged to:
Sector: Country Risk
Geography: India
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