India's PMIs recover ahead of today’s RBI policy review

Bank of Japan's surprise decision to cut deposit rates to negative and US Fed's pause has provided some relief to risk sentiments this week. The RBI is likely to predominantly factor in domestic developments today, as external risks stabilise. The benchmark rates are expected to be left unchanged. Stark rupee weakness at the start of the year will also add to the central bank's cautious mood. 

Inflation is off lows and back to more than a year's high. At the same time, the government's fiscal leaning at FY16/17 Budget due next month will also need to be factored in. The RBI is likely to monitor whether fiscal targets are adjusted and consider the rationale of any such change. The RBI would likely take a favorable view, if the additional fiscal room (higher deficit) is channelled towards higher capex spending and improvement in revenue collections. 

"We don't see a risk that RBI targets will be breached, the upcoming wage bill adjustment will influence the price outlook and inflationary expectations", says DBS Group Research.

There are signs that domestic growth is on the mend, while price indices remained firm. Jan16 manufacturing PMI jumped to 51.1 from Dec15's 49.1. This reinforces that one-off heavy floods in the southern part of the country had led to a notable deterioration in Dec, with restocking needs likely to add to the buoyancy at the start of the year. The consumer goods sector continues to drive the improving outlook, while investment-related demand remains subdued. Price sub-indices remained firm, adding to the gradual uptick in CPI/ WPI inflation in recent months. 

Beyond today's pause, a 25bps cut is expected in April (an inter-meeting move in March cannot be ruled out). Favourable base effects around mid-2016 will suppress headline inflation, providing another window (-25bps) to ease rates and plateau thereafter. But this trend will be dictated by fiscal policy decisions, especially the wage bill implementation. 

On-going liquidity squeeze has meanwhile been a concern. These tight conditions are likely to persist in the Mar quarter as a seasonal mandatory reduction in expenditure kicks in at the end of the fiscal year (Apr-Mar). Beyond the first quarter, liquidity conditions are likely to improve as government spending kicks off in earnest. Longer-term INR swap rates are looking past this temporary liquidity shortage.