Under the dark cloud of inflation: RBI’s fourth quarter mid-review of Monetary Policy 2010-11
The Reserve Bank of India (RBI) in its fourth quarter mid-review of Monetary Policy 2010-11 raised its key policy rates by 25 basis points as inflation remained above the tolerance levels of the central bank. The rate hike was despite tight liquidity situation prevailing in the system, right since October 2010, due to high credit demand and advance tax obligations.
Thus now the policy rates are as under:
Repo rate increased by 25 basis points from 6.50% to 6.75%; and
Reverse Repo rate increased by 25 basis points from 5.50% to 5.75%
Thereby maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis points.
However assessing the prevailing tight liquidity situation, the Cash Reserve Ratio (CRR) is kept unchanged at 6.00%.
[PersonalFN expected policy rates (both repo as well as the reverse repo) to increase by 25 basis points, in a move to tame inflation].
Statutory Liquidity Ratio (SLR) has also been kept unchanged at its last reduced level of 24% (In the third quarter mid-review of monetary policy 2010-11 on December 16, 2010 it was reduced from 25% to 24%) as tight liquidity situation continued.
Bank rate too has been left unchanged at 6.00%.
Reason for such a policy stance:
Expected outcome from the policy stance:
The central bank’s stance of increasing policy rates by 25 basis points is expected to:
- Continue to rein in demand-side inflationary pressures while minimise risk involved in growth; and
- Manage inflationary expectations and contain the spill-over of high food and commodity prices into more generalised inflation
What does the policy stance mean and its impact?
The repo rate is the rate of interest charged by the central bank on borrowings by the commercial banks. Increasing repo rate means, there will be increase in the borrowing cost of commercial banks. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may go up, as the commercial banks in the country may hike lending rates.
Similarly, the interest rates on fixed deposits are also expected to move upwards from the current levels. At present 1 yr FDs (Fixed Deposits) are offering interest in the range of 7.50% - 9.00% p.a.
The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Increasing them will result in commercial banks continuing to enjoy higher interest rates for parking their surplus funds with RBI.
The Statutory Liquid Ratio (SLR) is the amount that the commercial banks require to maintain in the form of cash, or gold or govt. approved securities before providing credit to the customers. Keeping them unchanged would help in keeping a check on the prevailing liquidity situation.
With the risk in growth in F.Y. 2010-11 mainly being on the upside, the RBI has retained the baseline projection of real
GDP growth at 8.6% taking into account the following factors:
- Continuing uncertainty about energy and commodity prices
- Weak performance of capital goods segment in the IIP (Index of Industrial Production)
- Pressures on the fiscal deficit
- Widening current account deficit (it has increased from U.S. $ 12.1 billion in Q1 of 2010-11 to U.S. $ 15.8 billion in Q2 of 2010-11)
What should Debt fund investors do?
The central bank’s stance of increasing the policy rates by 25 basis points reveals the central bank’s vigilance in taming intolerant levels of WPI inflation, in the scenario of expanding Indian economy. But if crude oil prices soar and prices of other non-food items move up, the “spill over" will continue to happen in generalised WPI inflation, thus building in inflationary pressures going forward. This will tempt the RBI to adopt its calibrated exit stance in future as well.
However now (by May 2011), in our opinion WPI inflation is likely to mellow down as the base effect fades away. This in turn will give some relief to the RBI and they may refrain from increasing policy rates further for at least some time, as the rise in interest cost would derail economic growth as borrowing cost would scale-up. Hence, that also in a way makes us believe that interest rates are close to peaking out.
Thus taking into account the above, we recommend that you now gradually take exposure to pure income and short-term Government securities funds, as interest rates are almost peaking out, making longer tenor papers look attractive. Longer duration funds (preferably through dynamic bond / flexi-debt funds) can be considered, if one has a longer investment horizon (of say 2 to 3 years).
But, if you have a short-term time horizon (of less than 3 months) you would be better off investing in liquid funds. Liquid plus funds can be considered if you have a 3 to 6 months horizon. However if you have a medium term investment horizon (of over 6 months), you may allocate your investments to floating rate funds.
Short term income funds should be held strictly with a 1 year time horizon. Fixed Maturity Plans (FMPs) of 3 months to 1 year can also be considered only if you are willing to hold it till maturity. This is because the short term rates are at present attractive and these FMPs can generate appealing yield for the investors. 13 to 15 months FMPs can also be considered in order to gain attractive post tax returns by availing the double indexation benefits.
You should invest in longer duration funds, if the time horizon is of over 2 to 3 years. But you may witness some volatility in the near term as there is always an interest rate risk involved in the longer maturity instruments.
You can consider investing your money in Fixed Deposits (FDs). At present 1 yr FDs are offering interest in the range of 7.50% - 9.00% p.a.
Long-term infrastructure bonds (offering tax benefit under section 80CCF of the Income Tax Act, 1961) can also be considered for availing income tax benefit beyond Rs 1 lakh limit availed under section 80C. However, one should consider those with high credit ratings and good post-tax yields.