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Why India’s rate hike was the right move

Why India’s rate hike was the right move

Resisting consensus calls, the Reserve Bank of India (RBI) hiked interest rates for the first time in four years on Wednesday, increasing the benchmark repo rate by 25 basis points to 6.25% while maintaining a neutral policy stance.

The Indian central bank joined emerging market counterparts in Indonesia, Turkey and Argentina despite market expectations of continuity in rates, in what was a first for both RBI governor Urjit Patel (pictured) and Prime Minister Narendra Modi.

‘Given domestic inflationary pressures and external risks, the pre-emptive move is the right one, in our view,’ Nomura analysts said in a research note. They added that the neutral policy stance suggests that India is not embarking on a tightening cycle.

The RBI statement noted concerns over hardening core inflation in April, which rose sharply to 4.6%, as well as rising crude oil prices, a key contributor to headline inflation - at 4.2% in April - for the oil importing economy.

The Indian crude basket, a weighted average of Dubai, Oman and brent crude oil prices, has surged by 12% to $74 per barrel since early April, and the monetary policy committee indicated a further increase in headline inflation to 4.7% in the second half of the year.

Moreover, the central bank said the growth outlook was strong, with real GDP forecast maintained at 7.4% for 2019. This view was driven by improved capacity utilisation, better credit off-take, pick-up in private investment activity and better prospects for the external sector and consumption.

The RBI has a mandate to keep headline inflation close to 4% in the medium-term.

‘Impact from the MSP [minimum support price] revision for "Kharif" crops while not yet quantified by the RBI, does pose an upside risk,’ added Sunil Sharma, chief investment officer at Sanctum Wealth Management.

In its latest budget announced in February, the Indian government proposed a hike in the support prices for monsoon crops but the RBI noted that it was too early to assess the impact of the revision due to a lack of adequate details.

Commenting on the policy development, Radhika Rao, economist at DBS Group Research said that the move did not come as a surprise as other Asian policymakers were also erring on the side of caution, preferring pre-emptive policy changes to reactive measures.

‘Investors have become sensitive to economies that face overheating risks, characterised by twin deficits and high inflation that could potentially unsettle macroeconomic stability,’ she said in a report.

So far, market reaction has been mixed, with 10-year bond yields inching up modestly to 7.92%. In contrast, equity markets have reacted positively and the rupee has gained against the dollar.

Rao expects another hike in either the August or the September meeting amid inflation concerns and consumption-focused policies such as the minimum support prices.

Fiscal slippage risks from a shortfall in privatisation receipts, downside in goods and services tax collections and need for fuel excise duty cuts are also on the horizon for the South Asia economy.

‘The pending minimum support price announcements are likely to be the next catalyst for the central bank to shift its inflation trajectory in the August meeting,’ she concluded.

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