Peak Repo Rate Seen At 5.5-5.75%, Above Pre-pandemic Level By August: Msp Hike For Kharif Crops (Monsonn/ Autumn Season) To Increase Inflation By 15-20 Bps

As widely expected, RBI’s Monetary Policy Committee unanimously decided to increase policy Repo rate by 50 bps to 4.90% while also remaining focused on ‘withdrawal of accommodation’ to ensure that inflation remains within the target going forward, all the while supporting growth. RBI has retained its real GDP growth forecast for FY23 at 7.2% with risks broadly balanced. However, inflation projection for FY23 has been revised upwards by 100 bps to 6.7% on account of several factors including tense global geopolitical situation, elevated commodity prices, adverse global supply conditions and heightened crude oil prices. Average crude oil price (Indian basket) assumption is now taken at $105 per barrel from $100 per barrel. With recent average 6% MSP hike for the kharif crops, there will be an upside pressure of 15 to 20 bps on inflation.

In terms of liquidity, the RBI has done a smart job and currently net LAF has declined to Rs 3.2 trillion from Rs 5.54 trillion as on March end. Core liquidity has also declined to Rs 7.1 trillion from Rs 8.3 trillion, of which Government cash balances is at Rs 3.5 trillion. We believe as the Government starts to spend towards the later part of the year, this may necessitate a CRR hike more as a policy tool to support OMO operations at a later date when Government borrowing picks up pace.

The regulatory changes announced by the RBI have mainly focused on increasing credit to construction/housing sector and some announcements in payments systems and margin requirements for Non-centrally Cleared Derivative contracts. The increase in limit on individual housing loans by cooperative banks and permitting Rural Cooperative Banks to extend finance to ‘commercial real estate – residential housing’ within the existing aggregate housing finance limit of 5% of their total assets will provide the necessary push to credit flow to housing sector. Additionally, linking of RuPay credit cards (CC) to UPI is expected to provide more avenues and convenience to 1.50 crore customers in making payments through UPI platform.

Meanwhile, the Governor has also alluded to the proactive role that fiscal policy can also play in unison with monetary policy as a coordinated attempt to control inflation. This could be achieved with state cutting VAT on fuel as a policy option to anchor inflationary expectations. Interestingly, economic literature suggests that a monetary policy contraction accompanied with fiscal policy expansion is the ideal coordinated policy outcome with the maximum payoff.

The policy also highlighted the global uncertainty with countries grappling with multi-decadal high inflation and slowing growth, persisting geopolitical tensions and sanctions, elevated prices of crude oil and other commodities and lingering COVID-19 related supply chain bottlenecks. As per World Bank’s latest assessment, global growth is expected to slump from 5.7 percent in 2021 to 2.9 percent in 2022— significantly lower than 4.1 percent that was anticipated in January. Russian invasion of Ukraine has magnified the slowdown in the global economy, which is entering what could become a protracted period of feeble growth and elevated inflation.

However, the good thing is that even as global uncertainties are in abundance, growth numbers continue to show optimism locally. Capacity utilization rates have now moved up to 74.5%, with new investment announcements at a record high of Rs 20 trillion in FY22 and manufacturing sector leading from the front. This will give more comfort to RBI in pushing through the rate hikes and controlling inflation as its primary and foremost option.

Against this background, we are now expecting that RBI could factor in a rate hike in August and even October policy also, and take it higher than pre-pandemic level by August to 5.25% and in October to 5.5%. Our peak rate at the end of the cycle now has now a lower bound of 5.5% and could go up to 5.75% depending on inflation trajectory. This is purely data dependent and subject to revisions.

However, we believe 10 year benchmark yields are likely to be capped at 7.5%, even assuming a 175 basis point spread over our peak repo rate at 5.75%. This is because, term premium is likely to be 50 basis points, factoring in a further market adjustment of 50 basis points over and above 5.75% as an insurance rate hike and an additional 75 basis points because of supply overhang. This makes the total spread of 175 basis points over 5.75%. Interestingly, the pre pandemic spread was around 135 basis points.

Finally, with EBLR linked loans gaining traction, repo rate increase will curtail inflation through the credit channel as well. As every 1 bps increase in repo has combined impact of ~ Rs 305 crore on demand from Retail & MSME Consumers, with terminal repo rate at 5.75% there will be reduction in demand from consumers to the tune of Rs 45,000 crore.

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