RBI's Stand On Rate Cuts: Will It? Will It Not?

As the guardian of the country’s monetary policy, the RBI’s stance on interest rates is keenly awaited. Saikat Mitra explains what the RBI’s action would mean for the market and what steps investors should take, whether the banker goes in for a rate cut or maintains status quo.

Key Points

• With central bankers across the globe cutting the benchmark rates in bid to spur growth, it remains to be seen whether the RBI will cut interest rates this time round or whether it will maintain status quo yet again.
• With inflation still above the comfort level, the only solid motivation for the RBI to go in for a rate cut is to spur economic growth, which will lead to better stock market performance.
• Given the current macro-economic situation, not just on the domestic front but also globally, the probability of the RBI maintaining status quo with respect to interest rates looks much higher. A large section of market intermediaries including brokers, fund managers and economists are of the view that a rate cut does not seem to be coming our way.

The actions of the RBI have never seemed to be as relevant as they seem today. In fact, interest rates are a macro factor remaining at the top of everyone’s agenda in recent times, from industrialists to policy makers and regulators.

With central bankers across the globe cutting the benchmark rates in bid to spur growth, the ensuing RBI policy meet is being awaited with bated breath. The People’s Bank of China (PBoC) cut the benchmark interest rate for the second time in a month July 5, reducing it by 31 basis points to six per cent. The Bank of Korea has lowered its key interest rate by 0.25 per cent, the first such instance in three years. Brazil and many European countries too have brought down their key rates.

In this background, the main question that each one is probably seeking an answer to is, will the RBI cut interest rates this time round, or will it maintain status quo yet again?

Around the time that you read this story, the RBI would have taken action on the interest rate front. Here, we would like to provide our readers with a course of action for both the circumstances that could probably emerge ahead.

Scenario 1

RBI Reduces Key Policy Rates

Let’s first look at a scenario where the RBI goes in for a rate cut on July 31st. If the central bank does so, it will surely boost the market sentiment and will act as a major trigger for economic growth. But is the RBI in a position to cut rates? With the macro situation still not very certain and inflation - which has been a major nemesis of the central banker - not cooling off, there are very few reasons for it to look at cutting rates. The only solid motivation for the RBI to go in for a rate cut against all odds is to spur economic growth. Lower interest rates will mean a lower cost of borrowing, and consequently higher spending and consumption. It would also revive the capex cycle, which has slowed down considerably or can be said to be dormant for now. All this means a decisive improvement in the overall economic and market environment, leading to better stock market performance.

Course Of Action

So, what should you do in case the RBI brings down the interest rates? Well, one has to look out for opportunities that will be value accretive in the true sense. If the interest rates go down, companies with high debt-to-equity (D/E) ratios will be in a position to breathe easy.

In such a situation, good companies that have been ignored only because of high debt on their balance sheet can be considered for inclusion in one’s portfolio. Also, companies in interest rate-sensitive sectors like banking, real estate and infrastructure, like IL&FS Transportation Networks ( D/E 3.32x) and Pratibha Industries (D/E 1.67x) to name a few, have the potential to outperform the markets and can be good bets going forward.

Scenario 2

RBI Maintains Status Quo On Policy Rates

Given the current macro-economic situation, not just on the domestic front but also globally, the probability of the RBI maintaining status quo with respect to interest rates looks much higher. A large section of market intermediaries including brokers, fund managers and economists are of the view that a rate cut does not seem to be coming our way. Dipen Shah, Senior Vice President (PCG Research), Kotak Securities says, “We do not think it (the RBI) will cut rates on July 31. Crude prices have started inching up once again, and the status of the monsoon is yet to become clear. Moreover, a rate cut may have implications for the rupee, which is trying to recover. The RBI may act once there is more comfort on these issues”.

As mentioned earlier, there are several factors that could prevent the RBI from reducing rates. The Wholesale Price Index (WPI) is still above its comfort zone (five to six per cent), and stands at 7.25 per cent for the month of June 2012. Also, crude prices have started inching up and the rupee is yet to stabilise. These are the macro indicators that may play their part in the RBI’s decision on whether to cut rates or not. "So long as inflation does not fall below six per cent, the RBI will stick with its stand of not cutting rates. They have already effected a 100 basis points cut earlier, which was unexpected. They will wait till inflation cools off", opines Kishore P. Ostwal, CMD, CNI Research.

Course Of Action

The RBI has mentioned earlier too that it is not its duty to spur growth by injecting liquidity. If it maintains status quo, we may see some kind of pessimism overshadowing the markets in the shorter term. However, rather than focussing on the pessimism, we should move ahead and look forward for other investment horizons in the equity space that will be value accretive for one’s portfolio. We believe that stocks from sectors like FMCG, pharmaceuticals and companies that have zero or negligible debt on their balance sheet are likely to be the best bets in this scenario. The probable beneficiaries are companies like Hindustan Unilever, Zydus Wellness and Divi’s Labs.

Show Of Hands

We conducted a poll, where leading brokers, fund managers and research houses have participated on what will be the RBI’s course of action when they meet on the July 31. We also ran the poll on our website www.dsij.in to get a pulse of the public opinion on the matter. The results of this poll were truly eye-opening.

Fund managers and brokers are of the view that the RBI is likely to maintain status quo. As many as 13 out of 20 respondents believe that there will be no rate cut this time. On the poll on the website that we ran for the public, 44 per cent of the respondents have voted in favour of expectations of a 25 basis points cut, while 34 per cent expect no rate cut. Thus, the markets are discounting a situation of no rate cut in the forthcoming meet.

All the speculation notwithstanding, it is well known that the central banker has a habit of surprising the markets. On our part, we believe that a rate cut is necessary to inject some kind of optimism into the markets, and this has been voiced by us earlier too. It is about time that we should face the reality.