Rate Cut a Positive Jolt for India?s Growth Dynamics

In a surprise move, the Reserve Bank of India (RBI) cut its policy rate for the first time in two years on Jan. 15 by 25 basis points (bps) to 7.75%.1 Encouraged by multiple anti-inflationary catalysts building up over the past few months — including lower commodity prices, a stable rupee, a favorable winter wheat crop and the government’s commitment to fiscal consolidation — the RBI instituted a rare inter-meeting rate cut.

Surprise likely signals more easing

Given that India’s year-over-year consumer price index came in for December at just 5%,2 we concluded that the RBI target of 8% for January 20153 has been safely achieved. While we believe the January 2016 target of 6% is still a challenge,3 the RBI stated that this goal is likely to be achieved in the established time frame. In our opinion, the RBI decided to begin off-cycle easing because of the likely positive jolt that a “surprise” may have on growth dynamics going forward.

We now believe the RBI will likely cut rates an additional 75 bps or so over the next year as long as inflation remains under control. Risks to our view include increasing current account deficit and/or rising food inflation. Likewise, a pronounced rebound in oil prices or significant increase in developed market rates would be negative, in our view. A failure to achieve fiscal consolidation is also a risk.

Rupee rally?

While perhaps counterintuitive, we believe the rupee may continue to strengthen despite lower rates. Given that the foreign institutional investor (FII) equity portfolio is around six times as large as the FII debt portfolio,4 the rupee typically has a much stronger correlation with equities than rates. For example, we saw the rupee strengthen by about 0.2% as the Sensex rose 2.6%5 in response to the surprise cut and investors’ perception of positive impact on growth.

Likewise, we believe that a favorable “cocktail” of lower rates, improving sovereign credit measures and efforts to cut “red tape” — measures that will realistically take perhaps many years to bear fruit — should attract incremental foreign direct investment flows as well. Nonetheless, we anticipate that the RBI’s stated goal of preventing what it sees as potential overvaluation of the rupee on a trade-weighted basis — as well as its desire to continue to build foreign exchange reserves beyond the current eight months of import cover — will limit any move beyond the range of 59 to 61 rupees against the US dollar.

Framework for macro stability

While still in early days, we believe the RBI’s astute management of monetary policy under the leadership of Governor Raghuram Rajan — in coordination with the administration of Prime Minister Narendra Modi and Finance Minister Arun Jaitley, who now clearly has the burden of presenting a credible spending plan for fiscal 2016 — has laid the framework for macro stability needed to achieve growth.

A credible reduction in interest rates, in conjunction with quashing recent volatility in both inflation and the US dollar/rupee exchange rate, will be key to engendering the kind of investment needed to meet the needs of India’s young and growing population, in our view. Despite encouraging growth and sentiment-friendly initiatives — such as the de-bottlenecking of major infrastructure projects, reducing policy uncertainty, addressing supply hurdles in the mining and power sector and significant efforts toward reducing corruption — we now believe that bringing down funding costs for Indian corporations and consumers will play a key role in India’s achievement of its long-term growth potential.

1 Source: Reserve Bank of India, Jan. 15, 2015

2 Source: Bloomberg L.P, Jan. 16, 2015

3 Source: Wall Street Journal, Aug. 27, 2014

4 Source: Merrill Lynch, “5% CPI Inflation Supports Our Feb. 3 Rate Cut Call,” Jan. 12, 2015

5 Source: Bloomberg L.P., Jan. 15, 2015

Important information

A basis point equals 1/100th of 1%. The consumer price index measures changes in the price level of a market basket of consumer goods and services purchased by households.

The Bombay Exchange Sensitive Index (Sensex) is composed of 30 of the largest and most actively traded stocks on the Bombay Stock Exchange.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

All data provided by Invesco unless otherwise noted.

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