The policy move is expected to suck the excess liquidity from the system in order to reduce the demand pressure. The move is also expected to reduce consumption spending with a view to pulling down the demand.

Impact Analysis:

1. The short-term loans would become dearer for both the corporate and individuals and will further discourage consumption. Over the last hike of 50 bps most banks would not have passed on the cost of capital, but with the fresh hike, we believe the banks will be under pressure to re-price their loan book to soften the blow to their NIMs. Resultantly, the EMIs will definitely go up.
2. From the economic perspective, the slow growth will hit tax collections, divestments, while upsetting the fiscal computations, and resultantly the Government may have to resort to a higher borrowing programme than envisaged, and this will haunt the markets in the short-term till the inflation is tamed.
3. Financing of interest rate sensitive sectors like Automobiles, Consumer Durables, Housing, Infrastructure etc., would be impacted.
4. Going forward, if high oil and other commodity prices persist, we could expect more tightening and the impact of the anti-inflationary monetary stance may stress growth.
5. The pace of industrial activity has been slowing primarily due to the impact of past policy measures and high input prices. The external demand too may witness slowdown if global recovery slackens.
6. With a decline in business confidence, it is natural to predict a moderation in new investment, which we believe will be sluggish. We expect that the existing investments i.e. in the power sector will continue and may get completed.
7. Growth is expected to moderate in FY12, even though the RBI is projecting a GDP of 7.5% to 8.4%. Despite being at 20.89%, the credit off-take could slow to 18-20% with the rate hike impact. It will come with a lag effect and we believe that the GDP could be more to the bottom of 7.5% or lower, in case further hikes are made to tame inflation or unless inflation slows down.
8. As far as banks are considered, the credit demand and liquidity are comfortable, which may not change much. The Banks may change the Base Rate/ BPLR, and the spreads would be adjusted on pricing to capture the hike.

Every Cloud has a Silver Lining – Hope

1. We are likely to witness a normal monsoon and there are indications of a record wheat crop. This means agricultural growth will normalise in spite of the higher base last year, and in turn support the GDP growth.
2. A normal monsoon will keep the food inflation downwards, which is evident from the fact that the primary article inflation has been declining since March 17, 2011. The manufactured products inflation has been rising from November 2, 2010, on the back of spiralling crude oil prices, and the wage-pressure in the manufacturing sector. While the GDP growth prospect is witnessing moderation with the rising crude prices, high inflation, and elevated interest rates.
3. The advance tax numbers do not reflect slowdown. But, if continued rate hikes take place to tame inflation, we might calibrate our growth forecasts of the economy and the companies.
4. The fiscal deficit – which has been swelling since Nov’10 on back of rising crude prices – has seen a decline by May’11 on excellent exports growth.
5. Overall economy has been slowing since the Mid-Cycle Review on May 2, 2011, on the back of rising crude prices that reflects higher inflation. We have a negative bias on the outlook for crude oil prices in the near-term (Please refer to our Report – “Current Crude Oil Prices Unsustainable in Our View – Expect Correction” – released on 7^th Jun’11”). Fundamentally, we believe crude oil seems to be unsustainable above US$100 per barrel on a prolonged basis due to decline in consumption on the back of potential inflationary pressures in the emerging economies, who are at the helm to drive crude oil demand. From technical perspective, while the long-term charts of crude oil suggest a bearish trend developing crude oil seems to be imitating the behaviour of Gold from 1981-1999, which was bear market for Gold. As crude oil prices soften and higher farm output on the back of a good monsoon policy rates will start to reverse, we believe we are at close to the peak of interest rates.

Risks to Our Call

Inflation has been a global phenomenon in terms of food inflation and commodity prices. If it persists we are going to see more policy stringent policy measures, which could haunt the markets further.

Our View on Markets

In our opinion, the next three months are going to be tough on the market, with the inflation staying at elevated levels. We believe that the investments cycle will slow down impacting demand and earnings growth rates. With current inflationary trends, the RBI’s GDP forecast seems to be ambitious, as the inflationary pressure poises significant risks to growth and earnings numbers for FY12. The banking and interest rate sensitive sectors will clearly have a visible negative impact. The banks have till now passed on the interest rate upswing in order to manage their NIMs, but this incremental hike would make scenario tougher with the slowdown in credit off-take. As the economy slows, the NPAs will start moving up. We don’t expect markets to react negatively on this policy given it was anticipated owing to the inflationary pressure. This expectation seems to be very realistic with the imminent revision in diesel price hike, as further inflationary scenario would spook the markets further, as the future policy rates will surely have an upward bias.