India gets aggressive with rate cuts

Reserve Bank of India will cut 50bps in benchmark policy rates which Morgan Stanley sees as a bold but risky move.

The easing is heavier than was expected, in what is now seeming to be a frontloading tactic that might reduce the cost of capital in the banking system. But it could backfire as banks struggle to cut their lending and deposit rates amid a still-wobbly macro environment of inflation pressures and tight liquidity.

Here's more from Morgan Stanley:

RBI reduced benchmark policy rates by 50bps: The Reserve Bank of India announced cuts of 50 bps each in repo and reverse repo rates, to 8% and 7%, respectively. We have been arguing that macro stability indicators warranted a delay in policy rate cuts for next 2-3 months. As such, this move was ahead of our expectations, since we viewed a rate cut as a low-probability outcome. The April 17 policy statement indicated that deceleration in growth below post-crisis trend and resultant moderation in core inflation have led to a change in policy stance.

RBI indicated limited room for further easing: While RBI reduced policy rates, we see this as front loading of the easing cycle, as the central bank has highlighted limited room for further easing. RBI noted that modest deviation in growth from its trend and upside risks to inflation limit the room for further easing. As such, we believe that the guidance indicates a further easing of 50bps in calendar year 2012 (cumulative easing of 100bps), which is in line with our earlier expectation of 75-100bps cumulative reduction in policy rates in 2012.

Effective reduction in cost of capital will still be a challenge: Persistent tightness in interbank liquidity conditions (loan-deposit ratio near an all-time high) has meant that interbank call rate has been largely trading above the repo rate. Indeed, we believe banks will struggle to pass on this easing in the form of a cut in lending/deposit rates unless there is a systemic improvement in liquidity conditions measured by loan-deposit ratio.

We see this rate-cut move as an aggressive strategy: We believe that if RBI does manage to reduce effective cost of capital in the banking system, we would be more worried about the macro stability risks. We believe that macro stability indicators - potential further worsening of current account deficit, tight interbank liquidity and resurgence in inflation pressures - warranted a delay in rate cuts.