In the Advance Economies (AEs) as many of you may be aware that the near-term risks have receded, with improvement in financial conditions and an accommodative monetary policy stance adopted thus far. However, it is noteworthy that this improvement is yet to transmit into economic activity which has remained rather subdued amidst signs of diverging growth paths across major economies. While the U.S. has exhibited signs of economic vigour (with improvement in housing sector and employment conditions), the economic recovery yet appears vulnerable due to budget sequestration. Speaking about the Euro zone, recessionary conditions, deteriorating industrial activity, weak export and low demand, double-digit unemployment levels and hesitant progress on financial sector repair have eroded consumer confidence. Among the BRICS nations (which include Brazil, Russia, India China and South Africa), growth has accelerated in Brazil and South Africa, while it has continued to be below trend in China, Russia and India. However when observed in several Emerging and Developing Economies (EDEs), growth has rebounded from moderation in 2012, as domestic demand rose with turnaround in inventory cycle and some pick-up in investment activity.

Speaking specifically about India, the GDP growth rate has been lowest level (at 4.5% in Q3FY13) in the last 15 quarters, which is reflecting a slowdown. This has mainly occurred on account of protracted weakness in industrial activity aggravated by domestic supply bottlenecks, and slowdown in the services sector (reflecting weak external demand). And now the Central Statistics Office (CSO)'s advance estimate of GDP growth of 5.0% in FY2012-13 implies that the economy would have expanded by only 4.7% in Q4FY13. It is noteworthy that cumulatively for the period April 2013 to February 2013 industrial activity has decelerated on an average to 0.9%, from 3.5% in the corresponding period of the previous year. The Reserve Bank of India's (RBI's) Order Books, Inventories and Capacity Utilisation Survey (OBICUS) also suggests that capacity utilisation remained flat. Moreover, composite purchasing managers' index (PMI), which encompasses manufacturing and services, fell to a 17-month low in March 2013. Thus all these factors suggest the fact that growth in Q4FY13 could remain low.

As far as Wholesale Price Index (WPI) inflation in India is concerned, at present it has moderated to 7.36% in 2012-13, from 8.96% in the previous year. After plateauing over the 7.00%+ mark for more than a year, prices have eased particularly in the last quarter of fiscal year 2012-13 with food inflation, manufacturing inflation and power & fuel inflation mellowing down.

  WPI Inflation mellowed down

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

 

Non-food manufactured products inflation which ruled above the comfort level in the first half of 2012-13 but declined in the second half to come down to 3.5% by March 2013 also brought relief and reflected easing of input price pressures and erosion of pricing power. However when observed the Consumer Price Index (CPI) inflation, it yet appears sticky as it averaged in double-digit at 10.2% in 2012-13, and there's yet a significant gap in WPI and Consumer Price Index (CPI) inflation.

Speaking about liquidity conditions, it remained under pressure throughout the year because of persistently high Government cash balances with RBI and elevated incremental credit to deposit ratio for much of the year. But in order to ease liquidity pressures, the Cash Reserve Ratio (CRR) was reduced on three occasions by 75 bps and Statutory Liquidity Ratio by 100 bps. Additionally, RBI injected liquidity to the tune of Rs1,546 billion through Open Market Operation (OMO) purchase auctions. It is noteworthy that the net injection of liquidity under the LAF, which peaked at Rs1,808 billion on March 28, 2013 reflecting the year-end demand, reversed sharply to Rs 842 billion by end-April 2013. The money supply growth (M3) during the fiscal year gone by, formed a 'U'-shaped curve as after being at around 14.0% during Q1FY13 and thereafter decelerating by end-December 2012 (as time deposits slowed down); it once again picked up with acceleration in deposit mobilisation in Q4FY13 deposit growth to 14.3% by end-March 2013 and consequentially reached 13.3% by end-March 2013, slightly above the revised indicative trajectory of 13.0%.

Going forward in fiscal year 2013-14, the RBI has identified the following risks to India's macroeconomic outlook; they are:
 

1. By far the biggest risk to the economy stems from the Current Account Deficit (CAD) which, last year, was historically the highest and well above the sustainable level of 2.5% of GDP as estimated by RBI. Admittedly, the fiscal deficit is programmed to decline, but even factoring that in, it is still high. Large fiscal deficits can potentially spill over into the CAD and undermine its sustainability even further. A large CAD, appreciably above the sustainable level year after year, will put pressure on servicing of external liabilities.
    
2. Even as the large CAD is a risk by itself, its financing exposes the economy to the risk of sudden stop and reversal of capital flows. Although the CAD could be financed last year because of easy liquidity conditions in the global system, the global liquidity situation could quickly alter for EDEs, including India, for two reasons. First, the outlook for AEs remains uncertain, and even if there may be no event shocks, there could well be process shocks which could result in capital outflows from EDEs. Second, with Quantitative Easing (QE), AE central banks are in uncharted territory with considerable uncertainty about the trajectory of recovery and the calibration of QE. Should global liquidity conditions rapidly tighten, India could potentially face a problem of sudden stop and reversal of capital flows jeopardising our macro-financial stability.
    
3. Sustained revival of growth is not possible without a revival of investment. But investment sentiment remains inhibited owing to subdued business confidence and dented business profitability. Both borrowers and lenders have become risk averse. Borrowers have become risk averse because of governance concerns, delays in approvals and tighter credit conditions. For lenders, risk aversion stems from the erosion of asset quality, deteriorating cash flow situation of borrowers eroding their credit worthiness and heightened risk premiums.
    
4. Looking ahead, the effectiveness of monetary policy in bringing down inflation pressures and anchoring inflation expectations could be undermined by supply constraints in the economy, particularly in the food and infrastructure sectors. Food price pressures, upward revisions in the Minimum Support Prices (MSPs) and rapid wage increases are leading to a wage-price spiral. Without policy efforts to unlock the tightening supply constraints and bring enduring improvements in productivity and competitiveness, growth could weaken even further and inflationary strains could re-emerge.
    

Monetary Policy Action...
Thus in the background of the aforementioned macroeconomic situation and to balance of risks between growth and inflation on the domestic front, it was decided by RBI as under:
 

• To reduce the repo rate from 7.50% to 7.25% (a reduction of 25 basis points (bps) with immediate effect); and
   
• Reduce reverse repo rate from 6.50% to 6.25%
   

Thereby, maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis points with immediate effect. Also the Marginal Standing Facility (MSF) rate, determined with a spread of 100 basis points above the repo rate also is thus adjusted to 8.25%, and so is the bank rate to 8.25% with immediate effect.

However, since CRR was already reduced by 200 bps since January 2012 to infuse liquidity and active management of liquidity vide Open Market Operations (OMOs) have also taken place, the CRR was kept unchanged at the current level of 4.0%.

  Policy rate tracker

	Increase / (Decrease) in FY12-13	At present
Repo Rate	(100 bps)	7.50%
Reverse Repo Rate	(100 bps)	6.50%
Cash Reserve Ratio	(75 bps)	4.00%
Statutory Liquidity Ratio	(100 bps)	23.00%
Bank Rate	(100 bps)	8.50%

(Source: RBI, PersonalFN Research)  

It is noteworthy that the monetary policy action is guided by the following considerations:
 

• Continuous deceleration in growth, which has led it to be halve from 9.2% in Q4FY11 to 4.5% in Q3FY13. Also the RBI's current assessment that activity will remain subdued during the first half of this fiscal year with a modest pick-up, subject to appropriate conditions ensuing, in the second half of 2013-14; and
   
• Ease in headline WPI inflation by March 2013, which has come closer to RBI's tolerance threshold. But food price pressures yet persist and supply constraints are endemic, which could lead to a generalisation of inflation and put strains on the balance of payments.
   

And now according to RBI, the stance of the monetary policy is intended to:
 

• Continue to address the accentuated risks to growth;
• Guard against the risks of inflation pressures re-emerging and adversely impacting inflation expectations, even as corrections in administered prices release suppressed inflation; and
• Appropriately manage liquidity to ensure adequate credit flow to the productive sectors of the economy
   

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. Reducing it would infer, borrowing cost of commercial banks may reduce. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may also ease, whereby home loans and car loans may be offered at a lower rate, thereby providing some relief to respective sectors.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Reducing them will imply that commercial banks would fetch lower interest rates as against what they were receiving earlier, 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, with not infuse further primary liquidity into the banking 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:

According to RBI policy action undertaken in this review carries forward the measures put in place since January 2012 towards supporting growth in the face of gradual moderation of headline inflation. However according to the central bank, the recent monetary policy action by itself, cannot revive growth. It needs to be supplemented by efforts towards easing the supply bottlenecks, improving governance and stepping up public investment, alongside continuing commitment to fiscal consolidation.

With upside risks to inflation still significant in the near term in view of sectoral demand supply imbalances, on-going correction in administered prices and pressures stemming from MSP increases, monetary policy cannot afford to lower its guard against the possibility of resurgence of inflation pressures, the RBI has said. Likewise according to RBI, Monetary policy will also have to remain alert to the risks on account of the CAD and its financing, which could warrant a swift reversal of the policy stance.

Overall according to the RBI, the balance of risks stemming from assessment of the growth-inflation dynamic yields little space for further monetary easing. The RBI endeavours to actively manage liquidity to reinforce monetary transmission, consistent with the growth-inflation balance.

Projections for domestic economic growth and inflation:

The Central Statistics Office (CSO) projected GDP growth for fiscal year 2012-13 at 5.0%, lower than the Reserve Bank's baseline projection of 5.5% set out in the 3rd quarter review of monetary policy, reflecting slower than expected growth in both industry and services. Going forward in 2013-14, the central bank expects the economic activity to show only a modest improvement over last year with a pick-up likely only in the second half of the year. Agriculture growth could return to trend level, but again conditional upon normal monsoon. The outlook for industrial outlook according to RBI yet appears subdued with the pipeline of new investment drying up and existing projects stalled by bottlenecks and implementation gaps. With global growth unlikely to improve significantly from 2012, growth in services and exports may remain sluggish. Accordingly, the baseline GDP growth for 2013-14 is projected at 5.7%.

Speaking about inflation, the RBI views the global inflation outlook for the current year to be more benign compared to last year on expectations of some softening of crude oil and food prices. Accordingly, imported inflation is likely to be lower provided the exchange rate remains broadly stable. However on the other hand, food inflation is likely to be a source of upside pressure because of persisting supply imbalances. Also, the timing and magnitude of administered price revisions, particularly of electricity and coal, will impact the evolution of the trajectory of inflation in 2013-14. Keeping in view the domestic demand-supply balance, the outlook for global commodity prices and the forecast of a normal monsoon, WPI inflation is according to RBI is expected to be range-bound around 5.5 per cent during 2013-14, with some edging down in the first half on account of past policy actions, although there could be some increase in the second half, largely reflecting base effects.

What should Debt fund investors do?

The guidance from the monetary policy enunciates that headroom for further monetary easing remains quite limited. The reduction of 25 bps from the RBI has been in line with expectation of the market which may not lead to much easing in short-term yields. The longer tenure papers, we think would take cues from how the country manages the twin deficit problem and inflation data. The RBI in its report on currency and finance 2009-12, has pressed on need to design credible fiscal consolidation plans and coordination strategies to ensure an appropriate fiscal-monetary mix. This according to the central bank will facilitate attainment of the growth target and more headroom for monetary policy to address macroeconomic goals. Thus the report has noted that careful calibration towards reverting to fiscal consolidation and proper assessment of any likely institutional changes in public debt management constituted key imperatives for the outlook of fiscal-monetary debt management coordination. It is noteworthy that, the Government has already announced a gross borrowing of Rs 3,49,000 crores (59% of the full year's budgeted borrowing) in the first half of 2013-14 and has initiated its borrowings for this fiscal.

At present while taking exposure to debt mutual fund schemes and fixed income instruments, it would not be very prudent to take exposure to longer duration instruments as most of the rally has already occurred ahead of expectation of a 25 bps policy rate cut from RBI, and now that the central bank in its guidance has indicated limited space for further monetary easing. In case if one wishes to take exposure to longer duration instruments or debt mutual fund schemes holding longer maturity papers (as permitted by their high risk appetite), PersonalFN recommends that you do so by investing in dynamic bond funds, since there would always be intermediate interest rate risk involved.

In the current scenario while investing in debt instrument, 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 1 ½ months, or liquid plus funds for next 3 to 6 months horizon. If you as an investor have a short to medium term investment horizon (of 1 to 2 years), you may allocate a part of your investment to short-term income funds, provided that you are willing to take some interest rate risk. 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 7.50% - 9.00% p.a.

 

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