Fighting Deflation in India Amidst Capital flow Vulnerabilities and Imminent US Fed Rate Hike

India's WPI came in yesterday at -2.06% an all time low. Crude prices certainly helped- but that does not take away the fear of deflation postponing purchasing intentions of consumers , globally and not just in India.

The Indian Government would like to have a considerably easier Monetary Policy than what the RBI is running at the moment. Political posturing aside, technically it is difficult in the face of volatile capital flows and an austerely-built FX reserve(USD 338 Bio) to cut rates when the US Fed is actually looking at hiking rates. To keep the USD/INR exchange rate stable, a potential cut of 100 bps in India's repo rate when Fed will be hiking by about 50 bps in the same duration, would require the Indian 10 year yield to move upto a level of UST 10 year + 570 bps(current spread) + 150 bps (100 bps +50 bps increase in divergence between Indian and US repo rates) = UST10 yr + 720 bps. So if the UST10 yr goes to 3% post Fed 50 bps rate hike by December end 2015, Indian 10 yr needs to be at 10.20% for the Indian Rupee to be stable. Any yield lower than 10.20% will cause the INR to depreciate. We examine 3 different scenarios assuming FX Reserves remain constant untill Dec'15.

Scenario.1 RBI cuts rates by 100 bps , and US Fed hikes rates by 50 bps by Dec'15.

On 31st Dec'15
INR10 yr yield                      USD/INR

10.20%                                       64.00
9.20%                                         67.15
8.20%                                         70.30


Scenario.2 RBI cuts rates by 50 bps , and US Fed hikes rates by 50 bps by Dec'15.

On 31st Dec'15
INR10 yr yield                       USD/INR

9.70%                                         64.00
8.70%                                         67.15
7.70%                                         70.30


Scenario.3 RBI cuts rates by 25 bps , and US Fed hikes rates by 50 bps by Dec'15.

On 31st Dec'15
INR10 yr yield                     USD/INR

9.55%                                         64.00
8.55%                                         67.15
7.55%                                         70.30

So, the lesser the rate cuts by the RBI and the lesser the rate hikes by the US Fed, stabler is the exchange rate for Indian currency. Ofcourse, there are growth and income considerations as well. But witness the exchange rate scare in 2013 when Fed taper tantrums riled India, this variable is definitely an important parameter. And the Indian 10 yr yield? In a scenario of increasing NPAs, Treasury Income is very important to allocate provisions against bad loan losses. Higher the yield, lower the Treasury Income.

So, rather than what the Indian Govt. thinks as a straight off no-brainer, reducing rates is an extremely complex optimisation program.