In recent times, the outlook for global growth has improved modestly. The fiscal concerns in the U.S. too seem have diminished and lead indicators in the U.S. and the Euro zone, seem to be firming up. The prospects of postponement of tapering of stimulus by the U.S. through winding down of their bond buying programme has also brought some relief to the Emerging and Developing Economies (EDEs) and that is evident through capital flows having resumed and its positive implication on the financial markets.

Speaking about India, while we 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 strengthening export growth and signs of revival in some services, along with expected pick-up in agriculture, could support and increase in growth in the second-half of the present fiscal year 2013-14; thereby raising real GDP growth rate from 4.4% in Q1FY14 to a central estimate of 5.0% for the whole fiscal year. The revival of large stalled projects and the pipeline cleared by the Cabinet Committee on Investment may buoy investment and overall activity towards the close of fiscal year.

  WPI Inflation inches-up again!

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

 

As far as WPI inflation is concerned, it has been on a rise since the last few months thereby making it obvious that inflationary pressures are creeping in and disturbing the moderation which was evident a few months ago. The pass-through of rupee depreciation into prices of manufactured products is acting, along with elevated food and fuel inflation, to offset possible disinflationary effects of low growth. While food price pressures may ease with the arrival of the kharif harvest and the usual seasonal moderation, overall WPI inflation is expected to remain higher than current levels through most of the remaining part of the year. Retail inflation as measured by the Consumer Price Index (CPI) has also remained elevated across food and non-food constituents, keeping inflationary expectations high. Such a scenario on inflation, according to the Reserve Bank of India (RBI) would warrant an appropriate policy response.

As far as the Current Account Deficit (CAD) is concerned, the improvement in performance of exports over the last couple of months along with contraction in non-oil import demand has enabled a perceptible narrowing of trade deficit, which has shown favourable implications for CAD. Policy interventions have bridged the external financing gap. These factors have brought some calm to the foreign exchange market. However according to RBI, normalcy will be restored to the exchange market only when the demand for dollars from public sector oil marketing companies is fully returned to the market.

Speaking about liquidity situation, liquidity upto 0.5% of bank-wise Net Demand and Time Liabilities (NDTL) is available through overnight Liquidity Adjustment Facility (LAF) repos. Furthermore, export credit refinances of upto 50% of eligible export credit outstanding amounts to approximately 0.5% of system-level NDTL. To provide market participants with additional access to primary liquidity, as well as greater flexibility in managing reserve requirements, term repos of 7-day and 14-day tenor have been introduced to provide liquidity equivalent to 0.25% of NDTL. Due to such measures taken to ease liquidity, the average drawal on the Marginal Standing Facility (MSF) has reduced significantly from Rs 1.4 trillion in mid-September to Rs 0.4 trillion by mid-October and market rates too have fallen by 125 basis points (bps).

Monetary Policy Action...
Hence in the backdrop of the aforementioned macroeconomic assessment, it was decided by RBI as under:
 

• To reduce MSF by 25 basis points (bps) from 9.00% to 8.75% with immediate effect;
   
• To increase the repo rate by 25 bps from 7.50% to 7.75% with immediate effect;
   
• To increase the reverse repo rate by 25 bps from 6.50% to 6.75% with immediate effect;
   
• To keep Cash Reserve Ratio (CRR) unchanged to 4.0% of NDTL
   
• To increase liquidity provided through term repos of 7-day and 14-day tenor from 0.25% of NDTL of the banking system to 0.50% with immediate effect
   

Thus, the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate was maintained at 100 basis points. Likewise with these changes the bank rate was recalibrated to 100 bps above the repo rate, placing it at 9.75%

 

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 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 would not infuse further primary liquidity into the banking system. But reduction in MSF would aid liquidity conditions along with term repos of 7-day and 14-day tenor.

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 liquidity conditions
• Curb mounting inflationary pressures and manage inflation expectations
• Help in strengthening the environment for growth by fostering macroeconomic and financial stability
   

Guidance from monetary policy and path for interest rates:

The Reserve Bank has made it clear that it will closely monitor inflation risk while being mindful of the evolving growth dynamics.

What strategy should debt investors should adopt?

Liquidity position and path for interest rates
The guidance from monetary policy has made it clear that inflation would remain under focus while being mindful of the growth dynamics. With liquidity concerns having addressed with the steps thereto taken, shorter maturity papers would see softening in yields. But at the longer end of the yield curve, due to inflationary pressures evident and RBI focus thereon; yields of longer maturity papers may remain under pressure with macroeconomic concerns on inflation, fiscal deficit and sovereign rating.

So in the aforesaid backdrop, PersonalFN is of the view that, it would be best to refrain investing in longer maturity debt papers, 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 8.00% - 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 1month, or liquid plus funds for next 3 to 6 months horizon.

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