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RBI Policy - How will rupee react?

RBI Policy - How will rupee react?

  • Date05 Aug 2020
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The RBI monetary policy is due on Thursday. The market is pricing in a 55% probability of a 25bps rate cut which would take the repo rate to 3.75% and reverse repo rate to 3.10%. To aid the economic recovery process the RBI may look through the recent inflation print and frontload the rate cut as it would be more effective. Monsoon and Kharif sowing seems to be progressing well and that should keep inflation in check going forward. Though some greenshoots are visible if one looks at high frequency indicators such as passenger vehicle sales, rural consumption, e-way bills generated, there are serious question marks around the sustainability of the recovery as localized lockdowns continue in many parts of the country. The durable component of the recovery in demand may be much smaller in comparison to the pent up demand component of the lockdown period.

 

Given that this RBI regime is not averse to using unconventional tools, there is a possibility that we could see the repo-reverse repo corridor being widened or even possibly the introduction of special deposit facility (SDF) 30-40bps lower than the reverse repo rate alongside a cap on amount the banks can park with RBI in reverse repo. The intent would be to disincentivize banks from parking funds with the RBI and to encourage them to lend instead. Other steps that could be taken to make banks less averse to lending would be allowing a one time restructuring of stressed assets. Moratorium extension could be granted only to specific sectors. In order to facilitate absorption of duration supply and to contain term premiums, the RBI may increase the amount of bonds banks can hold in their HTM (Held to Maturity) portfolio. Bonds in this portfolio do not need to be marked to market.

 

If the messaging from the RBI comes across as anything less than dovish, it would spook money markets and we could see the impact further up the term structure as well. We could see a sell off in bonds and the yield curve could steepen. This would further decelerate the economic recovery process. The RBI is therefore likely to keep its signalling or messaging clear that it would continue to prioritize growth over inflation at this point.

 

It would undo all the good work it has done so far if it all of a sudden turns its focus on inflation. As it is it's decision should be based on core inflation and that is still quite soft. In the event of a rate cut/widening of repo-reverse repo corridor or introduction of SDF, we could see forwards get received. A dovish policy would be overall positive for the Rupee, stocks and bonds. Usdinr premiums could also come off.

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