When you watch an exciting sport on television and you know the team you are backing is likely to lose the game, you don’t stop cheering for them do you? You always expect some magic to happen and the team to win in the end.

The world of Finance too is getting exciting these days, amid clamour for rate cuts, and the Reserve Bank of India (RBI) has surprised everyone this time.

In its fourth bi-monthly monetary policy statement for 2015-16, the RBI has cut policy rates by 50 basis points (bps) ahead of festivities of Dussehra and Diwali. Here are the highlights:
 

• The repo rate under the liquidity adjustment facility (LAF) has been reduced from 7.25% to 6.75% with immediate effect;
• The reverse repo rate has been reduced from 6.25% to 5.75%
• The cash reserve ratio (CRR) of scheduled banks however is left unchanged at 4.0% of net demand and time liability (NDTL);
• Moreover, the RBI has decided to continue to provide liquidity under overnight repos at 0.25% of the bank-wise NDTL at the LAF repo rate and liquidity under a 14-day term repos, as well as longer term repos of upto 0.75% of the NDTL of the banking system through auctions; and
• Decided to continue with daily variable rate repos and reverse repos to smoothen liquidity.
   

It has brought in cheers after a clamour for rates; but truth be told, it wasn’t an easy decision for the Central bank this time. While domestic factors favoured a rate cut, global factors weren’t supportive. The RBI was on the horns of a dilemma about policy rates, and has gone ahead doling out a bonanza which could potentially provide the impetus for economic growth.

So what led the RBI to reduce policy rates?

• Inflation has dropped to a nine-month low, as projected. The fall in inflation has been across the board, and inflation excluding food and fuel has also come off its recent peak in June.
• Despite the monsoon deficiency and its uneven spatial and temporal distribution, food inflation pressures have been contained through resolute actions by the government to manage supply.
• The Federal Reserve has postponed policy normalization.
• Markets have transmitted the Reserve Bank’s past policy actions via commercial paper and corporate bonds (but banks have done so only to a limited extent).
• RBI further believes the outlook on food inflation could improve if the increase in farmed areas translates into higher production.
• Still-low industrial capacity utilisation indicates more domestic demand is needed to substitute for weakening global demand in order that the domestic investment cycle picks up.
   

The RBI has also accounted for the Pay Commission Report which will be due for presentation soon. This may provide impetus for demand. However going by the assurance of the Government, it will stick to fiscal deficit targets and improve the quality of spending. The RBI believes the monetary policy has to be optimally supportive.

The assessment drawn...
Since the RBI announced its Third bi-monthly monetary policy statement (on August 4, 2015), economic growth, especially in the emerging markets, softened. With deteriorating global trade, RBI perceives that the downside risk has further increased. The RBI assessed Emerging Market Economies (EMEs) that are caught in a vortex of slowing global trade volumes, depressed commodity prices, weakening currencies, and capital outflows, which accentuates country-specific domestic constraints. As far as China’s devaluation of Renminbi goes, the central bank has reckoned that while this is mild, it has unsettled financial markets across the world.

On the domestic front, the RBI has observed that economic recovery underway, but still far from being robust. The manufacturing sector has exhibited uneven growth in April-July, with industrial activity slowing sequentially in July, though it has been in expansionary mode for the nine consecutive months. In agriculture, the sown area has expanded modestly from a year ago, reflecting the timely and robust onset of the monsoons in June, but the Southwest monsoon is currently deficient by 14% - with the production-weighted rainfall deficiency at 20%. Nevertheless, the first advance estimates indicate that food grain production is expected to be higher than last year, reflecting the actions taken to contain the adverse effects of rain deficiency through timely advisories and regular monitoring of seed and fertiliser availability. The central bank also believes that allied farming activities, which are more insulated from the monsoon, remain resilient and could partly offset the effects of adverse weather on crop production.

Tepid aggregate demand and deceleration in corporate staff cost has made the inflation target set for January 2016 look more realistic and achievable now. However in the short term, i.e. from September onwards, inflation bps may move up for a few months as the favourable base effects wane.

Guidance...
While the Reserve Bank’s stance will continue to be accommodative, the focus on monetary action for the short term will shift to working with the Government. This will ensure that impediments to banks passing on the bulk of the cumulative 125 basis points cut, in the policy rate, are removed. The RBI will continue to be vigilant for signs where monetary policy adjustments are needed to keep the economy on the target disinflationary path.

How have the markets reacted and why...
Both equity and debt markets have reacted positively to the monetary policy action. There are a slew of measures taken by RBI that may encourage investors to participate in financial markets.
 

• Based on the comments received on the draft framework and in consultation with the Government, it has been decided to permit Indian corporates to issue Rupee-denominated bonds with a minimum maturity of five years at overseas locations, within the ceiling of foreign investment permitted in corporate debt (US$ 51 billion at present). There shall be no restriction on the end usage of funds except for a small negative list.
• The limits for Foreign Portfolio Investors (FPI) investment in debt securities will henceforth be announced/fixed in Rupee terms.
• The limits for FPI investment in the central government securities will be increased in phases to 5% of the outstanding stock by March 2018.
   

These measures are intended to provide a more predictable, supportive investment climate.

And what’s score for borrowers?
Banks will reduce interest rates further as a measure for the transmission of policy rates. So availing a home loan, car loan etc. will get more economical.

PersonalFN is of the view that the Government may now nudge public sector banks to set the trend and start passing on the benefits of the lower policy rate regime to the common man. If this happens, it might pave the way for sustained lower interest rate regime for longer, provided other factors too remain supportive.

What investors should do?
The longer end of the yield curve seems to look attractive once again. But while you may want to take the risk, refrain from investing more than 20% of your allocation in debt funds. We suggest you consider dynamic bond (as they are enabled by their investment mandate to take positions across maturity profile of debt papers) and provided you have an investment horizon of at least 3 years.

In case you have a timeline horizon of less than a year, you should stay away from funds with longer maturities. If you have a short-term investment horizon of 3 to 6 months, you could consider investing in ultra-short term funds (also known as liquid plus funds). And if you have an extreme short-term time horizon (of less than 3 months), you would be better-off investing in liquid funds.

Alternatively, if you are risk averse, you can also invest in Fixed Deposits (FDs) before banks lower interest rates.

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