RBI Hikes 25 bp But Needs To Get More Aggressive

By Win Thin

Reserve Bank of India hiked interest rates by 25 bp yesterday, as expected. Reverse repo rate is now 5.5% and the repo rate 6.5%. The RBI said it will hold its mid-quarterly policy review on March 17 under the recent switch to more frequent meetings. Usually, the RBI meets quarterly but the extended gap between meetings led to several intra-meeting moves this past year and so the RBI now meets about every 6 weeks instead of quarterly. We think another hike then is likely, as RBI has turned slightly more hawkish after coming under increased scrutiny for being behind the curve. CPI inflation has eased but is still at very elevated levels and is likely to move higher as WPI inflation picked up to 8.4% y/y in December from 7.5% y/y in November. The RBI boosted its WPI inflation forecast, noted that inflation expectations remain elevated, and said that the need persists for steps to limit inflation.

We note that GDP growth surging, up 8.9% y/y in both Q2 and Q3 10, further tightening is warranted. Bloomberg consensus is for only one more 25 bp hike this year in Q2 but we think this understates likely tightening and that at least another 75 bp will be seen in 2011. We note that reserve requirements have not been hiked since April 2010, and look for RBI to again use this channel for tightening in the coming months. Commercial credit growth was 27% y/y in December, highest since October 2008, while M3 growth was 18% y/y and rising. It’s not just food prices that are driving inflation higher, but widespread strength in activity and so the RBI really must get more aggressive. RBI Governor Subbarao was quite clear when he said that "The current growth-inflation dynamics in the last few weeks suggest that the balance of risk has tilted toward intensification of inflation."

Despite the prospects of strong growth and higher interest rates, INR is the second worst performer for Asia EM so far in Q1, down 2.2% vs. USD. The rupee was in the middle of the pack in Q3 and Q4, but what’s changed is that markets this year are punishing countries perceived as being behind the inflation curve. Turkey, Indonesia, and perhaps the Philippines can be put in this camp, and these currencies have been amongst the worst EM performers YTD. USD/INR is slightly higher on the day despite the RBI rate hike, and next target is the November 30 high around 46.12. After that is the August high around 47.10. INR fundamentals aren’t terrible, but perceptions of being behind the curve are likely to really weigh on Indian assets and the rupee in the coming weeks unless credibility can be regained. A bigger hike today would have helped, but in the absence of that, the RBI should hike reserve requirements soon to help improve market sentiment. Lastly, strong growth has led to a wider current account deficit that is likely to come in close to -3.5% of GDP this year. This is not yet at danger levels, but the increase is a cause for concern in a region where current account surpluses are the norm.