In recent times, while the economic growth rate has picked up in the Advanced Economies (AEs) and there have been reports of the Euro zone exiting recession, the recovery yet appears weak. Likewise activity in the Emerging Market Economies (EMEs) has slowed down buffeted by heightened financial market turbulence on the prospect of tapering of Quantitative Easing (QE) in the U.S. But just recently, the U.S. Federal Reserve refrained from reducing the pace of the current bond buying programme (of U.S. $85 billion per month) due to lack of strong evidence of solid economic growth; and this has buoyed the financial markets. But the fact is tapering is inevitable.

Speaking about India, we too have undergone a slowdown which is distinctly evident vide dwindling quarter-on-quarter (Q-O-Q) GDP growth rate and lull in industrial activity. The pace of infrastructure project completion too is subdued and new project starts remain muted. However, consumption has been relatively firm thus far, but again consumption in the rural area seems to have weakened. Also consumption of durable goods, has taken a beating.

  WPI Inflation inches-up again!

Data as on August 2013
(Source: Office of the Economic Advisor, PersonalFN Research)

 

While WPI inflation did depict a descending move and moderated sub-5.0% mark for couple of months, in the last few months inflationary pressures have disturbed the moderation in WPI inflation and once again inflation is inching upwards as pass-through of fuel price increases has been compounded by the sharp depreciation of the Indian rupee and rising international commodity prices. But fortunately, above normal monsoons have brightened the prospects of agricultural produce (kharif crops), which in turn would be beneficial for exports as well. Nonetheless, the current assessment is that in the absence of an appropriate policy response, WPI inflation will be higher than initially projected over the rest of the year.

What is equally worrisome is that inflation at the retail level, measured by the CPI, has been high for a number of years, entrenching inflation expectations at elevated levels and eroding consumer and business confidence. Although better prospects of a robust kharif harvest will lead to some moderation in CPI inflation, there is no room for complacency.

As far as the Current Account Deficit (CAD) is concerned, the external factors, weakening domestic saving, subdued export demand and the rising value of oil imports - most recently due to geopolitical risks emanating from the Middle East - have led to a larger CAD. In the recent past concerns over CAD were amplified by capital flows precipitated by talks of tapering of bond-buying programme of the U.S. Federal Reserve, which in turn led to the volatility in the foreign exchange markets. But with the measures taken by the Reserve Bank of India (RBI) and the Government in the recent past to address to concerns of CAD and falling rupee (vide environment of external financing), some respite has been seen for rupee, which has subsided the volatility therein as well. Now the focus has turned to internal determinants of the value of the rupee, primarily the fiscal deficit and domestic inflation. It is noteworthy that the Food Security Bill passed recently in the Lok Sabha, has a support of Rs 1,30,000 crore (the largest in the world) and that subsidy in itself has an effect of putting a burden on country’s fiscal deficit, although Finance Minister Mr Chidambaram is confident that the fiscal deficit would be contained at 4.8% of GDP.

Speaking about liquidity situation, since mid-July 2013 RBI has put in an exceptional measure to tighten liquidity [vide increase in Marginal Standing Facility (MSF) to 10.25%] with a view to dampen the volatility in the foreign exchange market. The intent has been to maintain tight liquidity conditions at the short end of the term structure until the measures designed to alter the path of the CAD and improve prospects for its stable funding take effect. And now since a number of these measures are now in place and external environment has improved along with assessment of current and evolving macroeconomic situation, the monetary policy stance is as under:

Monetary Policy Action…
 

• To reduce MSF by 75 basis points (bps) from 10.25% to 9.5% with immediate effect;
   
• To reduce the minimum daily maintenance of the Cash Reserve Ratio (CRR) from 99% of the requirement to 95% effective from the fortnight beginning September 21, 2013, while keeping the CRR unchanged at 4.0%; and
   
• To increase the repo rate by 25 bps from 7.25% to 7.50% with immediate effect; and
   
• To increase the reverse repo rate by 25 bps from 6.25% to 6.50% with immediate effect
   

Thereby, maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis. The Marginal Standing Facility (MSF) too therefore stands changed to 200 basis points (bps) above the repo rate. Likewise the bank rate which is adjusted in congruence to MSF also stands changed to 9.50%.

  Policy rate tracker

	Increase / (Decrease) since FY12-13	At present
Repo Rate	(150 bps)	7.50%
Reverse Repo Rate	(150 bps)	6.50%
Cash Reserve Ratio	(75 bps)	4.00%
Statutory Liquidity Ratio	(100 bps)	23.00%
Bank Rate	(50 bps	9.50%

Data as on September 20, 2013
(Source: RBI, PersonalFN Research)  

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 the same would infer, borrowing cost of commercial banks will go up. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may also not ease - in fact go up, thereby making home loans and car loans expensive.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Increasing it will imply that commercial banks would fetch a little more interest rate as against they were receiving in the past, 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. Keeping it unchanged will not infuse further primary liquidity into the banking system. But reducing the minimum daily maintenance of CRR from 99% of the requirement to 95% (effective from the fortnight beginning September 21, 2013) would provide some marginal relief to banks.

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 help credit flow in the system – especially to productive sectors, which could be address growth risk.

It is noteworthy that according to the RBI, stance of the monetary policy is intended to:
 

• Normalise the conduct and operations of monetary policy so as to allow the LAF repo rate to resume its role as the operational policy interest rate
• Anchor inflation and inflationary expectations
• Mitigate exchange rate pressure
• Creating an environment for revitalising sustainable growth
• Manage liquidity conditions by reducing short-term interest rates in a calibrated manner and reducing minimum daily maintenance of CRR by banks.
   

Guidance from monetary policy and path for interest rates:

The Reserve Bank will closely and continuously monitor the evolving growth-inflation dynamics with a readiness to act pre-emptively, as necessary. The policy stance and measures set out in this review begins the process of cautious unwinding of the exceptional measures, which will restore normalcy to financial flows. They are also intended to address inflationary pressures so as to provide a stable nominal anchor for the economy, thereby mitigating exchange market pressures and creating a conducive environment for the revitalisation of sustainable growth.

What strategy should debt investors should adopt?

As seen above, in the guidance from monetary policy the RBI has mentioned that it would continuously monitor the evolving growth-inflation dynamics with a readiness to act pre-emptively, as necessary. It has also been mentioned by the central bank that further actions need not be announced only on policy dates; so vigilance appears. Moreover, focus has turned to internal determinants of the value of the rupee, primarily the fiscal deficit and domestic inflation.

PersonalFN is of the view that, ahead of the general election next year (in 2014), with the Government is loosening its purse strings challenges to the path of fiscal consolidation remain which also infuse a risk of rating downgrade. It is noteworthy that pressure could be felt at the longer end of the yield curve. Thus betting on longer end of the yield curve may be risky even if you have a longer time horizon.

So in the aforesaid backdrop, PersonalFN is of the view that, it would be best to refrain investing in longer maturity debt papers in the aforesaid backdrop, and instead prefer shorter maturity debt papers. If permitted by your time horizon and risk appetite if you still want to invest in long-term debt funds, it would be wise to take exposure via dynamic bond funds (as enabled by their mandate they hold debt instruments across maturities). But PersonalFN thinks that given the aforementioned interest rate scenario and macroeconomic variables thereto, one should not hold more than 20% of their debt portfolio in longer tenure funds. Avoid investing in G-sec funds, as they may see high volatility and may not be an ideal instrument to yield fruitful returns. Fixed Maturity Plans (FMPs) of 3 months to 1 year period can also be considered as an option to bank FDs only if you are willing to hold it till maturity. Alternatively you can also invest in 1 year Fixed Deposits (FDs), as banks are offering interest on 1 year FDs in the range of 8.25% - 9.00% p.a. In the present scenario, it would be ideal to invest in shorter duration instruments vide debt mutual fund schemes having shorter maturity profile. Investors with an extreme short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1½ month, or liquid plus funds for next 3 to 6 months horizon.

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