Amid challenging global environment and fractured growth observed in India; Reserve Bank of India (RBI) over again demonstrated its levelheadedness. RBI has been facing mounting pressure from all sides to reduce policy rates in order to help stimulate growth. However, India’s Central Bank remained committed in its determination to rein in inflation by keeping policy rates untouched. Nonetheless it ensured the liquidity situation remains under control.

In quarter ended September 30, 2012, growth remained subdued in many parts of the world. Economic activity in Japan and China further slackened during this period. EuroZone continued to rumble under recessionary pressure and showed little improvement. However, there were some positive surprises too. Growth numbers in United States came in better than that in the previous quarter. Britain’s economy too picked up for the first time in the last 4 quarters. Central Banks in many leading economies including United States and Japan announced monetary easing programs to prop up troubled economic activities. However, India’s Central Bank remained an exception to this.

Indian economy has been growing at a sub 6% rate since Q4 of 2011-12. Though Q1 of 2012-13 was slightly better; the headwinds have been strong. Considering this, RBI has revised the growth forecast to 5.8% in the current fiscal. This has been considerably lower than 6.5% predicted earlier. Demand-supply imbalances and higher commodity prices in the international market have resulted in sustained inflationary pressure. Moreover, wage increase in urban as well as rural India has been a major reason behind persistently high inflation.

  The Inflation bug!

(Source: Office of the Economic Advisor, PersonalFN Research)

There have been several upward revisions in the WPI inflation which clearly indicates the severity of the conundrum. RBI expects inflationary pressures to persist throughout the current fiscal and has upped the baseline projection for WIP inflation to 7.5% (March 2013) from 7.0% quoted earlier. To attain fiscal prudence, the government recently decided to cut its subsidy bill by hiking diesel and LPG prices. This would further add to inflationary pressure which was supressed till now.

The intent of monetary stance essentially remains to contain inflation and anchor inflation expectations. Along with this managing liquidity optimally is also a focus area of monetary policy. This may eventually assist in getting the growth back on track. The government, through various policy announcements, has already set a tone for bolstering growth momentum.

Monetary Policy Action…
 

• Reduced the Cash Reserve Ratio (CRR) of scheduled banks by 25 basis points (bps) (i.e. from 4.50% to 4.25%) with effect from November 03, 2012
   

But has kept policy rates unchanged as under:
 

• Repo rate at 8.00%; and
   
• Reverse repo rate at 7.00%
   

Thereby, maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis points. Also the Marginal Standing Facility (MSF) rate, determined with a spread of 100 basis points above the repo rate stands unchanged at 9.0%. Likewise the Bank Rate was also left untouched at 9.0%


 

Policy rate tracker

	Increase / (Decrease) in FY12-13	At present
Repo Rate	(50 bps)	8.00%
Reverse Repo Rate	(50 bps)	7.00%
Cash Reserve Ratio	(50 bps)	4.25%
Statutory Liquidity Ratio	(100 bps)	23.00%
Bank Rate	(50 bps)	9.00%

(Source: RBI, PersonalFN Research)  

The 25 bps reduction in CRR is expected to consequentially inject around Rs 17,500 crore of primary liquidity into the system. This would ease up the liquidity pressures experienced in recent times and take care of any liquidity crunch that might take place on account of currency demand arising during the festive season. The Central Government has held back the cash it collected through various activities such as bond auctions and advance tax payments. This is clearly reflected in borrowing by banks under Liquidity Adjustment Facility (LAF) which averaged around Rs 87,100 crore during October 15-25. LAF borrowing in June-September quarter averaged at Rs 48,600 crore.

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. Keeping it unchanged means, borrowing cost of commercial banks would remain unchanged. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may not change significantly, although commercial banks in the country may like to reduce lending rates ahead of the festive season, and since it is well supported by the liquidity infusion due to a CRR cut.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Keeping them unchanged will result in commercial banks fetching the same interest rate, as what they are receiving so far, for parking their surplus funds with RBI.

The Cash Reserve Ratio is the amount of liquid cash which the banks are supposed to maintain with RBI. Reducing the same, as said above would infuse short-term liquidity in the system.

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 it unchanged at the last reduced level of 23.00% could improve credit flow in the system – especially to productive sectors, and thereby support growth.

Guidance from monetary policy and path for interest rates:

Since the 1st quarter review of monetary policy 2012-13, growth risks have increased, but inflation risks still persists. While monetary policy has an important role in supporting the growth revival, it is perceived by the RBI that inflationary pressures persists along with risk from twin deficits i.e. current account deficit and fiscal deficit, which are constraining a stronger response of monetary policy to growth risks. Thus as this process evolves, the stance of monetary policy will be conditioned by careful and continuous monitoring of the evolving growth-inflation dynamics, management of liquidity conditions to ensure adequate flows of credit to productive sectors and appropriate responses to shocks emanating from external developments.

Also over the last few weeks, based on initiation of policy action from the government, both equity and debt markets were eagerly expecting the next cut in repo rate and CRR. The RBI’s decision of reduction in CRR by 25 bps and no change in repo rate has disappointed the markets as they reacted negatively. We expect that further rate cuts would depend on inflation trajectory despite slowdown in growth. In the near term, we expect the 10 year G-sec yield to stay in the range of 8.10% to 8.25%.

What should Debt fund investors do?

Looking at the growth-inflation dynamics, interest rates are likely to hover around the present elevated levels, until signs of moderation in WPI inflation are evident.

Hence at present while taking exposure to debt mutual funds and fixed income instruments, one should clearly know one’s investment time horizon. Investors with a very short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1 ½ months or liquid plus funds for next 3 to 6 months horizon. However, investors with a short to medium term investment horizon (of 1 to 2 years) may allocate a part of their investments to short-term income funds which should be held strictly with at least 1 year time horizon.

The present scenario also seems comfortable to look at longer horizon debt mutual funds. Thus, if you have a longer time horizon, then you can hold some exposure to pure income funds. Since longer tenor papers will become attractive, longer duration funds (preferably through dynamic bond / flexi-debt funds) can be considered, if one has an investment horizon of say 2 to 3 years. However, one may witness some volatility in the near term as there is always an interest rate risk associated with longer maturity instruments.

Fixed Maturity Plans (FMPs) of upto 1 year may, for some more time, yield appealing returns and can also be considered as an option to bank FDs only if you are willing to hold it till maturity. You can consider investing your money in Fixed Deposits (FDs) as well, before the interest rates offered on them are reduced further. At present 1 year FDs are offering interest in the range of 7.25% - 9.00% p.a.

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