FX comment – RBI cuts repo rate by 25bp; weaker INR outlook expected

by: Roy Teo

  • RBI cuts repo rate by 25bp in an unscheduled meeting today
  • Strong INR and declining inflation provide scope for rate cuts
  • Weaker INR outlook

RBI cuts repo rate by 25bp in an unscheduled meeting today

This morning, in an unscheduled monetary policy meeting, the Reserve Bank of India (RBI) reduced the policy repo rate by 25bp to 7.5% with immediate effect. The need to act outside the policy review cycle was prompted by two factors. First, policy action should be anticipatory given the weak state of certain sectors of the economy. The next bi-monthly policy statement is due only on 7 April. Second with the release of the agreement on the monetary policy framework, it is appropriate for the RBI to offer guidance on how it will implement the mandate. Indeed the RBI stated that they seek to bring the inflation rate to the mid-point of the band of 4+/-2% by the end of the two year period starting fiscal year 2016-17.

Strong INR and declining inflation provide scope for rate cuts

Besides the need to support economic growth, the RBI has also stated that the resilient Indian rupee (INR) and declining inflationary pressures have provided flexibility for looser monetary policy settings. Indeed inflation has declined to 5.1% in January with the central bank on target to meet its 6% inflation goal by January next year. Furthermore, the INR has appreciated by more than 2% (nominal effective exchange rate) and 4% (real effective exchange rate) against its trade weighted basket of currencies since the second half of 2014.

Weaker INR outlook

Looking at the rise in foreign currency reserves in the central bank, we suspect that the RBI could be intervening in the currency market to weaken the currency in the last quarter of 2014. Indeed, foreign exchange reserves have risen by almost 6% from July 2014 to February 2015, covering more than 10 months of imports. The RBI has also previously stated that though large foreign exchange reserves will provide greater ammunition to defend weakness in the INR, it comes at a cost given lower returns in foreign currencies. Given the postponement of fiscal consolidation to 3% target by one year, aggregate demand is expected to rise. The need to support exports growth which was in negative territory in December last year and January this year via a weaker exchange rate is hence necessary. We expect the RBI to lean against any strength in the INR towards 61 against the US dollar. Our year end target for USD/INR of 64 remains unchanged.