RBI to hold rates

We expect Reserve Bank of India (RBI) Governor Raghuram Rajan to continue to pause on June 3. After all, CPI-based inflation is peaking off, although El Nino risks are rising. Second, high rates are delaying recovery. Finally, we expect RBI to continue to ensure rupee stability by recouping foreign exchange (FX) reserves. In Delhi, Finance Minister Arun Jaitley has already laid out his agenda of restoring growth, containing inflation and fiscal consolidation.

CPI-based inflation is likely topping off with the rabi harvest cooling agflation. It will abate to 7 per cent levels - below the RBI's 8 per cent target - by March 2015, if rains are normal. While "core" CPI-based inflation is stuck at about 8 per cent, that is partly because housing price inflation is over-estimated at 10 per cent. April Wholesale Price Index (WPI)-based inflation has slipped to a benign 5.2 per cent. Although an El Nino could push CPI-based inflation to 10 per cent levels by September, the new government could focus more on supply management measures to combat rain shocks as the previous NDA regime did during the drought of 2002.

Second, although growth has bottomed, there is no sign of recovery. In our view, lending rates need to come off for growth to recover. While many pin hopes on fast tracking project clearances, investment will pick up only when lending rate cuts revive demand. Although it is fashionable to recall how the last up cycle of 2004-08 was driven by higher investment, this was itself driven by Governor Bimal Jalan's sustained easing during 1998-2004.

Finally, we expect RBI to continue to recoup FX reserves to stabilise the rupee. Given a low 8-month import cover, we fully agree with Governor Rajan's reluctance to use appreciation to fight inflation now. At the same time, it is his accumulation of FX reserves that will itself sustainably strengthen the rupee over time to counter "imported" inflation. A peak off in rate cycle will also help the rupee by attracting portfolio flows. After all, the FII investment in equities that responds to growth, is, at $250bn, almost 10 times that of FII investment in debt, that may respond to higher rates.