Another 75 bp of Hikes to Come

Before yesterday's (3 May) Reserve Bank of India meeting, we had expected a total of another 50 bp in policy rate hikes, sticking with our long held view that the repo rate would peak at 7.25% in July. That 50 bp move came through in one go, however, inevitably leading us to review our forecasts.  We have decided to make a significant change to the view, now expecting another 75 bp of hikes, with the repo rate peaking at 8% by September this year.  The key reason for the change is not so much the 50 bp move itself but rather Governor Subbarao's statement. There he surprised us by expressing a willingness to sacrifice some growth to calm inflation, while also indicating a reluctance to wait and see what the lagged effects of the policy tightening to date would be. The additional rate increases make us more secure in our below consensus growth forecasts. Not only do we look for 7.5% GDP growth in 2011/12, but we are expecting the same outturn in 2012/13. The “new” hikes will have a more of an effect on 2012/13 growth given the long lags involved with rate changes. Not only did the Reserve Bank of India increase the repo and reverse repo rates by 50 bp (to 7.25% and 6.25%, respectively, bringing the total increase to 250 bp and 300 bp) at yesterday's meeting but also hiked the savings deposit rate (the administered rate commercial banks must pay on some savings deposits) for the first time in years, from 3.5% to 4.0%, as well as increasing loan provisioning requirements for non-performing loans. All in all, the meeting signaled a heightened disquiet from the RBI concerning the stickiness of inflation and the fear that this would damage the country's medium term growth prospects. Exactly why this has taken so long to materialise given that inflationary pressures have been so high for so long is somewhat puzzling. Better late than never, however. Several commercial banks in India have already raised their deposit and lending rates by 25-50 bp in reaction to the RBI's move, while others have indicated their intention to do so shortly. As such, it is clear, that the vast bulk of the policy rate changes will be passed on to savers and borrowers. The accompanying statement from the RBI surprised us in three ways. First, an open acceptance by the central bank that some growth would need to be sacrificed in the short term at least in order to calm inflationary pressures. Second, the implicit reluctance of the RBI to wait and see what the lagged impact of the tightening that has already taken place would be on growth and inflation. Third, the heavy emphasis on the vagaries of WPI inflation, which most acknowledge is a poor indicator of underlying inflationary pressures. It seems highly likely that the shock March inflation release (where headline WPI was reported at 9.0%, driven up largely by the manufacturing component) was the tipping point for a 50 bp hike, rather than the normal 25bp move. With all this in mind and given the prospect of WPI inflation remaining uncomfortably high over coming months (we expect the headline rate to stay above 8% for the first half of the fiscal year, probably touching 10% in the not too distant future), further rate action looks highly likely. We are therefore lifting our interest rate call - expecting another 75 bp of hikes in total, which would take the repo rate up to a peak of 8.0% before the end of the July-September quarter. The next move is likely to come at the next meeting in mid-June and, at this stage, we have pencilled in a 25 bp hike. Clearly, however, a 50 bp increase can't be ruled out given the RBI's current hawkishness. The prospect of another 75 bp of rate hikes makes us even more secure in our bottom-of-the-range GDP growth forecasts. So far we have focussed 7.5% projection for 2011/12, but we also have the same number for 2012/13. Given that it typically takes 12-18 months for rate increases to feed through to the real economy, it is next year's growth that will feel the impact of the additional hikes. As far as we are aware, no one else has a growth forecast below 8% in 2012/13. Overall, the Indian economy and markets are facing a particularly unpleasant combination of macroeconomic circumstances right now. That is high and rising inflation, high and rising interest rates and the likelihood of downside growth surprises. This is also set to continue for some months, in our view, making it hard to remain anything other than pessimistic about the equity market outlook and somewhat cautious about bonds.