India: The Reserve Bank hikes Repo Rate by 25bps

The RBI has delivered its verdict. Clearly, the central bank believes that high oil prices are here to stay for some time, and that a continuation of complete fiscal absorption of the oil shock is not feasible. The RBI's choice was between 1) holding fire and waiting longer, hoping for oil prices to ease or 2) acting in small steps early enough to attack inflationary expectations without hurting growth materially. The central bank has now committed itself to sacrificing growth while honouring its commitment to the anchoring of inflationary expectations and price stability. Going forward, the oil price outlook is crucial.

Base case: 25bps Repo Rate hike in the next 3-4 months and another 25bps in October 2005

Our base case for oil is that prices will remain at or above current levels through the Northern Hemisphere winter, but ease back in 2005 to average USD38 per barrel. Near-term firmness in fuel costs will prompt the RBI to hike the Repo Rate by another 25bps by January 2005. This is in line with its desire to control inflationary expectations. However, if oil prices fall in line with our view in 2005, the RBI would probably hold ground until October 2005. By that time the investment recovery will have matured and overheating concerns alone will lead to further tightening by 25bps.

If oil prices do not decline next year, then the stage will be set for more aggressive tightening. So far, fuel subsidies have prevented even the first order impact of high international prices from affecting the economy. Also, the government seems to have decided against complete fiscal absorption should oil prices settle permanently higher. Domestic fuel costs will be incrementally increased and monetary policy will be gradually tightened to subdue inflationary expectations to prevent the passthrough of the supply shock into core inflation. If international crude prices do not recede, 100bps of hikes in the Repo Rate can be expected over the next 12 months. The RBI has also commented that the liquidity overhang remains substantial. In view of this, the RBI could hike reserve requirements further. It is also possible that RBI tightens by stealth by making the system net short on liquidity. In this case, the call rate could hit the Reverse Repo rate (6%) for an extended time period.

Growth and inflation forecasts adjusted in line with expectations

In view of the sub-par monsoon, the RBI has adjusted its GDP growth forecast to 6%-6.5% from 6.5%-7% issued in the Annual Policy statement. Our forecast is at the lower end of this range at 6%. The inflation forecast has been adjusted higher to 6.5% for end-March 2005, in line with our view. This forecast assumes that international commodity prices do not climb further. The RBI seems optimistic about the investment recovery and expects the exceptional credit growth observed in the early part of the fiscal year to be sustained. It is this comfort on growth that has prompted the RBI to concentrate on controlling inflation expectations. The only hope for the bond market is a sustainable fall in oil prices. For the INR, the direction of the USD is more important. That said, higher rates will certainly provide flow support.