WILL DR. RAJAN’S POLICY PRESCRIPTION CURE INDIA?

Takeaway: India may finally be starting on the long road to correcting its structural imbalances.

SUMMARY BULLETS:

 

  • Aided by new RBI governor Dr. Raghuram Rajan’s appropriately hawkish monetary policy, we think the Indian economy may finally be starting on the long road to correcting its structural imbalances.
  • That said, however, any meaningful adjustments will require the Indian economy to “take its medicine” by undergoing short-term pain for the sake of long-term gain.
  • Perhaps most importantly, it is still unclear how much of that “prescription” will be tolerated ahead of next year’s parliamentary election.
  • A more-traditional hawkish monetary policy mix should provide some support for the rupee over the intermediate-term TREND, though that same mix should weigh on India’s equity and debt capital markets over a similar time frame.

 

Overnight, new RBI governor Dr. Raghuram Rajan hiked rates. That’s a big deal in India, where, despite the country having a near world-beating inflation problem over that time frame (YoY WPI has averaged +7.1% since 3Q11), the RBI has not hiked either of its benchmark policy rates until now. In fact, those rates have been cut by a cumulative -125bps since peaking in OCT ’11.

 

WILL DR. RAJAN’S POLICY PRESCRIPTION CURE INDIA? - 6

 

Bravo, Dr. Rajan. Bravo.

 

On the move, both the repo and reverse repo rates were increased +25bps to 7.5% and 6.5%, respectively. The cash reserve ratio was held flat at 4%. Inclusive of today’s price action, 1Y OIS are now trading at a 135bps premium to the repo rate; that premium has shrunk -131bps MoM amid pro-EM FX Global Macro beta, but is still up +113bps on a 3M basis.  

 

WILL DR. RAJAN’S POLICY PRESCRIPTION CURE INDIA? - 5

 

Interestingly, despite the INR being down -13.4% vs. the USD over the past 6M, not one of the 36 analysts surveyed by Bloomberg expected Dr. Rajan to hike rates.

 

WILL DR. RAJAN’S POLICY PRESCRIPTION CURE INDIA? - 2

 

Perhaps Bloomberg should’ve surveyed us; it would appear that we were the only firm openly expecting Dr. Rajan to come out of the box in a hawkish manner (refer to our AUG 6 note titled, “WILL THE INDIAN RUPEE MEET ITS [NEW] MAKER?” for more details).

 

Even more interestingly, by cutting the marginal standing facility and bank rates by -75bps each (both are now at 9.5%) and lowering the daily balance requirement for the cash reserve ratio to 95% from 99%,  Dr. Rajan started to unwind former RBI Governor Duvvuri Subbarao’s previous “extraordinary” measures designed to curb volatility in the rupee.

 

It is our view that these incremental measures should be taken as a message to market participants that Dr. Rajan won’t try to be as cute as his predecessor when it comes to defending India’s currency. Thus far, Dr. Rajan has introduced himself to market participants as a monetary traditionalist who favors using blunt policy tools to get the job done.

 

The one caveat being that on SEP 4 Dr. Rajan offered concessional swaps for Indian banks’ FX deposits, with the intent of boosting the country’s FX reserves. That being said, the rupee was still in the process of making all-time lower-lows back then, so we’ll write that off as a one-time deal.

 

Let us refocus our attention back to his current job, which he himself has defined as needing to tackle India’s inflation problem [via promoting currency strength and tightening domestic monetary conditions]. Per this morning’s commentary:

 

  • “We want to fight against inflation and we’ll bring it down. The goal is to slow wholesale price inflation to below 5%.”
  • “Today’s steps start the process of a cautious unwinding of exceptional measures taken since July to reduce exchange rate volatility.”
  • “They also intend to address inflation risks to mitigate pressure on the rupee and create conditions for revitalizing expansion.”

 

Amalgamating all of these signals leads us to conclude what we had already concluded six weeks ago – Dr. Rajan will be more hawkish than his predecessor Duvvuri Subbarao, who was obsessively focused on stimulating economic growth to a fault (something we have written about many times in our bearish work on India over the years).

 

So what does this all mean to India’s GROWTH/INFLATION/POLICY dynamics?

 

It’s safe to conclude that India is likely to finish the year mired in Quad #3 (i.e. Growth Slowing as Inflation Accelerates), as reported inflation plays catch-up to recent currency weakness. Moreover, too much foreign capital has been withdrawn from the Indian economy in recent months (-$1.9B out of India’s equity market and another -$9.1B out of India’s credit market since MAY) for us to expect anything but sequential deterioration in real GDP growth throughout 2H13.

 

WILL DR. RAJAN’S POLICY PRESCRIPTION CURE INDIA? - INDIA

 

WILL DR. RAJAN’S POLICY PRESCRIPTION CURE INDIA? - 8

 

The aforementioned outflows have certainly weighed on India’s local currency fixed income markets (2Y Yields +21bps DoD and +126bps on a 3M basis; 10Y Yields are up +37bps DoD and +118bps on a 3M basis) and we anticipate Dr. Rajan will continue to perpetuate selling pressure via continued hawkishness over the intermediate term.

 

WILL DR. RAJAN’S POLICY PRESCRIPTION CURE INDIA? - 3

 

WILL DR. RAJAN’S POLICY PRESCRIPTION CURE INDIA? - 4

 

India’s equity market is tougher call from here.

 

We could see a scenario whereby the market “pulls and Indonesia” and starts to celebrate rate hikes as a newfound commitment to economic sobriety; recall that India’s twin deficits (current account and fiscal balances) are in the double digits on a combined basis. If India can shore up its current account imbalance by tightening the screws on domestic demand, we would view that as positive for India’s long-term economic outlook.

 

WILL DR. RAJAN’S POLICY PRESCRIPTION CURE INDIA? - 9

 

On the flip side, it’s tough for us to get to a scenario whereby we see commensurate fiscal tightening out of Indian parliament – especially not with a parliamentary election that needs to be called by MAY ’14. If anything, Prime Minster Singh will be under political pressure to continue “buying votes” like he did back in AUG with his food distribution bill, which plans to spend 1.25T INR per annum (equivalent to 7.5% of budgeted expenditures for FY14) on delivering grain to the Indian poor (i.e. two-thirds of the population).

 

Rather than get too cute with making a low-conviction bull call here on Indian equities, we’ll just stick to our process and anticipate continued weakness over the intermediate term (a couple of quarters in Quad #3 tends to be particularly bearish for a country’s equity market). That is in line with the signal the SENSEX Index provided us on today’s rate hike news.

 

WILL DR. RAJAN’S POLICY PRESCRIPTION CURE INDIA? - 1

 

All told, aided by new RBI governor Dr. Raghuram Rajan’s appropriately hawkish monetary policy, we think the Indian economy may finally be starting on the long road to correcting its structural imbalances. That said, however, any meaningful adjustments will require the Indian economy to “take its medicine” by undergoing short-term pain for the sake of long-term gain.

 

Perhaps most importantly, it is still unclear how much of that “prescription” will be tolerated ahead of next year’s parliamentary election.

 

Have a great weekend,

 

Darius Dale

Senior Analyst