RBI rate cut: Picture perfect for Growth

A surprise rate cut by the Reserve Bank of India (RBI), bringing the repo rate down by 25 basis points to 7.75% has cleared the ground for the economy to start moving in the growth path.

The move
The latest reading of near-zero whole sale price inflation (with inflation from manufactured products and fuel and power contracting) and consumer price inflation at 5%, well within the RBI’s comfort zone, appears to have advanced the policy rate cut. It was widely believed that a rate cut would be closer to the Budget in end-February.

A 25 basis point per se is not a game changer in terms of its impact. However, the move is significant for 2 reasons:

One, it clearly gives a directional shift in the RBI’s rate stance. As the RBI has repeatedly mentioned that once the monetary policy stance shifts, policy actions will be consistent with this stance. Hence, this rate cut can be expected to remain in that direction.

Two, the timing of the rate cut synchronises well with lower inflation buttressed by lower global commodity prices as well as a sharp pick up in the reforms momentum. All three factors, interest rates, inflation and reforms would go to drive the investment activity in the economy – aiding growth.

However, as mentioned in our earlier note, we maintain that rate cuts would be measured rather than large cuts at a time. The current move by the RBI appears to suggest just that.

Impact
For the debt market, the December 2014 policy meet provided enough cues for an impending rally. Our view on the debt market remains the same – we are probably now in the middle cycle of a debt rally. Longer duration bonds will continue to gain from this rally.
We think the current rate cut is a more significant one for the equity market. The thumbs-up given by the stock market today is evidence to this.

With deposit rates already being cut and more to come, it is a matter of time before borrowing rates too, are cut. This could, with some lag, aid credit growth and help companies plan their investment/capex activities.

A pick up in corporate earnings growth, in a few quarters from now, appears likely – backed by reforms, a congenial climate for investment and an improved demand scenario. This could trigger another leg of re-rating for companies in sectors that benefit both from lower interest cost and lower input costs (coming from lower commodity prices).

Investors would do well not to get too carried away by today’s market rally (or get disappointed for not participating). While the opportunity in debt could be broad based, in equity, this would be a year for quality opportunities that are best tapped using the mutual fund route in a disciplined way.