Risk of once-in-100-year drought means one more India rate cut

[MUMBAI] The risk India will suffer below-average monsoon rain for a third year, a once-in-a-century event, probably means the central bank has room for just one interest-rate cut before an extended pause.

Thirty-three of 37 economists surveyed by Bloomberg see the Reserve Bank of India lowering the repurchase rate to 6.5 per cent from 6.75 per cent on Tuesday, one predicts no change while three forecast a reduction to 6.25 per cent. That's where the benchmark will stay through September 2017, according to the median in a separate survey published March 31.

Two years of back-to-back drought have meant India's reservoirs are three-quarters of the past decade's average. Water scarcity could hurt crops, worsen price pressures and dent growth in Asia's third-biggest economy. RBI Governor Raghuram Rajan would also be wary of the recent recovery in oil prices that could imperil inflation targets.

"It's difficult to see a clear roadmap for further cuts beyond April, as the RBI may be concerned about uncertain monsoon rains and a rebound in oil prices," said Gaurav Kapur, a senior economist in Mumbai at Royal Bank of Scotland Group Plc. "The central bank would also like to see how a reduction in small savings rates and new rules for banks to calculate their lending rates translate into better policy transmission." Finance Minister Arun Jaitley in his Feb 29 budget retained a pledge to shrink the fiscal deficit to a nine-year low, soothing RBI concern that government stimulus would stoke prices. Calls for a rate cut intensified after data mid-March showed consumer-price gains in February rose 5.18 per cent, the least in four months and much lower than the 5.52 per cent increase economists estimated.

Jaitley on March 30 reiterated a demand for lower borrowing costs. History shows that India hasn't had three back-to-back droughts in at least 100 years and a new rate-setting system that takes effect April 1 will ensure commercial lenders pass on the central bank's reductions much quicker to customers, he said. The government last month also slashed interest rates on small savings, which competed with banks for deposits.

The lowest rainfall since 2009 parched vast tracts of farm land, hurting rice, corn, sugar cane and oilseed crops last year. About half of India's 1.3 billion population is employed in agriculture, which accounts for roughly 18 per cent of the nation's US$2 trillion gross domestic product.

"This is going to be the last rate cut by Rajan," said Rajeev Malik, Singapore-based senior economist with CLSA Asia- Pacific Markets, who expects the repo rate to be cut by 25 basis points on Tuesday and be held at that level until March 2017. "He has to keep in mind that he can't cut too much now and then realize the inflation guidance of 4 per cent by early 2018 look pretty difficult to achieve." Sovereign bonds have rallied after the government's budget restraint in anticipation of monetary easing. The yield on benchmark 10-year notes slumped 16 basis points last month, the best March performance for the debt since 1999. It fell another one basis point on Monday to 7.45 per cent, set for its lowest close since July 2013. The rupee climbed 3.3 per cent in March, the most since September 2013. It weakened 0.2 per cent Monday to 66.35 a dollar.

A new methodology for setting banks' lending rates is another factor that could discourage further easing by Rajan, whose term ends in September. The shift to the use of marginal cost of funds in determining loan charges is more closely aligned to the market and aimed at improving transmission of the RBI's previous borrowing-cost reductions. Rajan may want to wait and judge its effectiveness.

Banks currently use average costing to determine their base rates. This method of calculation has allowed lenders including State Bank of India, the largest, to reduce their base rates by about 70 basis points or less, much lower than the RBI's 1.25 percentage-point cut in its benchmark since the start of 2015. SBI's base rate stands at 9.3 per cent.

Strong El Nino conditions over the Pacific Ocean that began in 2015 are still continuing, according to a statement from the India Meteorological Department last week. While they may weaken in the middle of 2016, any delay would mean bad news for India's rainy season, according to Tata Asset Management Co. Brent crude prices climbed 14 per cent in the last two months, rebounding from a 12-year low of US$27.10 a barrel in January. India imports about three quarters of its oil.

"Assuming the monsoon is good and commodity prices remain stable, I think there is scope for another 25 basis point cut after April," said Anjali Verma, an economist at PhillipCapital Ltd. If not, she added, "this will be the last one for a long time."

BLOOMBERG