Dr Rajan Does The Unexpected, Follows Subbarao’s Legacy

The RBI has again lived up to the expectations of doing the unexpected and not bowing to market sentiment. Even though there was a change in guard at the country’s apex bank, Dr Raghuram Rajan has decided to swim against the tide by increasing the repo rate by 25 basis points. The markets reacted to this news negatively and cut the gains heavily by afternoon. The indices managed to recover partially by closing, but remained below yesterday’s closing level.

In other measures, the RBI has reduced the marginal standing facility (MSF) rate by 75 basis points from 10.25% to 9.5% with immediate effect. It has also reduced the minimum daily maintenance of cash reserve ratio (CRR) from 99% of the requirement to 95% with effect from the fortnight beginning September 21, 2013.

The reverse repo rate under the liquidity adjustment facility (LAF) is now adjusted to 6.5% and the bank rate stands reduced to 9.5% with immediate effect. The bank rate and MSF are recalibrated to 200 basis points above the repo rate.

In the press conference, Dr Rajan said that the short-term rate is much higher than the repo rate, and hence, the higher repo rate would not have much impact on growth. Just like Dr Subbarao, he indicated that inflation remains his main target. He also said that there could be room for a rate cut if the rupee stabilises in the next few days. However, we reckon that there would not be any rate cut in the October meet.

The governor also assured that funding the current account deficit (CAD) is not a big issue and can be done without drawing much from the country’s forex reserves. With regard to reduction of the MSF and bank rate, he said that the cost of funding for the banks has increased far too much, and the measure is an attempt to moderate it. On capital control, he said that the bank has no such plans.

It should be noted that the a few emerging economies which are facing currency woes have also increased their repo rates. Many market players as well as experts had expressed the belief that the RBI does not have any room for a rate hike. However, Dr Rajan has proved everyone wrong with his decision.

The Indian markets had a knee-jerk reaction on the policy announcement. Eventually, however, the rupee saw a recovery from yesterday’s closing.

We expect that the markets would forget the RBI’s action by Monday and would look forward to the quarterly results. At this juncture, it is not a good idea to invest in rate-sensitive sectors. Defensives would outperform the broader indices.