Nomura says the Indian rupee is fundamentally poised to weaken, however, with the RBI keen on defending the currency, further measures to tighten liquidity and potentially even a repo rate hike cannot be ruled out

The Reserve Bank of India (RBI) left the repo rate and the cash reserve ratio unchanged at 7.25% and 4.00%, respectively, in line with the consensus and expectations. "Because of the uncertainty on the timing of the reversal of these measures and implications of higher overnight rates, we see limited reasons to believe that front-end rates will reverse any time soon. In fact, we think Mumbai inter-bank offer rate (MIBOR) and overnight call fixings will continue to track the marginal standing facility (MSF) rate at 10.25% and, therefore, even if front-end rates move lower initially on dovish interpretations of the RBI, they are unlikely to stay lower," said Nomura Financial Advisory and Securities (India) Pvt Ltd, in a report.

Nomura said, there were no surprises in the RBI statements from a rates market perspective. If anything, the RBI explicitly suggested in its guidance that it is looking at rolling back the liquidity tightening measures in a calibrated manner, when the rupee stabilises.

The key statement in RBI guidance was "the recent liquidity tightening measures by the Reserve Bank are aimed at checking undue volatility in the foreign exchange market and will be rolled back in a calibrated manner as stability is restored to the foreign exchange market, enabling monetary policy to revert to supporting growth with continuing vigil on inflation."

"Though explicit mention of rollback qualifies for a less hawkish than market ‘feared’, we think it is too open a statement to get excited on the dovish side, as it doesn’t provide any timeline on the rollback of tightening measures," Nomura said.

The RBI revised down its GDP growth projection to 5.5% y-o-y in FY14 (year ending March 2014) from 5.7% earlier due to tepid global growth and persistent weakness in industrial activity. The RBI modified its WPI inflation projection - it expects WPI inflation of 5% by March 2014 as compared with around 5.5% y-o-y during FY14.

In Nomura's view, the policy game-plan is as follows...

The RBI's tight liquidity stance should help stabilise the currency. The government will use this 'window of opportunity' to announce reforms to narrow the current account deficit. As the currency stabilises the RBI will reverse these liquidity-tightening measures and start cutting rates to support growth. Indeed, the RBI has mentioned multiple times, both in yesterday's macroeconomic report and today's policy document that the current tightening measures are temporary and the government should use the breathing space provided by the RBI measures to announce structural reforms. So what can be the likely government response?

Nomura says in its view, the government is likely considering multiple options to garner dollars such as tapping non-resident Indian (NRI) deposits, swap lines with other countries, sovereign bond issuance. Additionally, import duties on consumer goods and luxury items may be imposed. If gold imports remain high, then further quantitative restrictions may be imposed.

While the RBI has guided that these measures are temporary, there is no guarantee that depreciation pressures will end within that timeframe. Concerns over (US) Fed quantitative easing (QE) tapering and slowing emerging market (EM) growth mean investors remain cautious on EMs, hence external financing difficulties may continue for much longer, Nomura said.

"Alternatively, the government's policy response during the next few months may not satisfy investors that fundamental/sustainable solutions are being put in place. In this situation, rupee may continue to weaken. However, the longer the depreciation pressure continues, the longer the tightening measures will need to remain in place and the greater the stress on domestic balance sheets of banks and corporates, leading to higher credit risk. Or the RBI will have to let the currency adjust in line with fundamentals, once the 'temporary' phase expires", it said

"In fact, by sending confusing signals in today's policy on whether it is trying to defend the currency (tighter policy) or wanting to support growth (looser policy), there is a growing risk that the rupee will depreciate and the RBI will need to enact further measures to tighten liquidity, potentially having to hike the repo rate. We assign a 20% probability," the report said.

According to Nomura, the Indian economy and policymakers are caught between a rock and a hard place. "In our view, rather than artificially trying to draw a line in the sand on the currency at the cost of creating a domestic credit crisis, policymakers should allow a gradual currency depreciation and the government needs to significantly tighten its fiscal belt and announce real reforms rather than band aid solutions. We remain negative on India's economic outlook over the next nine months due to deteriorating external finances, feedback effects from a weak rupee and likely policy responses, a poor growth outlook and the election cycle."

"In our baseline scenario (we attach a 70% likelihood), we expect repo rates to remain on hold this fiscal year and GDP growth at a below-consensus 5.0% y-o-y in FY14, the same as in FY13, despite better agriculture growth. We pencil in 75bp of cumulative repo rate cuts in FY15," Nomura added.