Since the 3rd quarter review of monetary policy 2012-13 (held on January 29, 2013), the global market conditions have shown signs of improvement, although there’s yet a mixed picture portrayed. It is noteworthy that GDP growth rate of the U.S. economy has shown signs of improvement, with progress in housing and payroll employment data; but the macroeconomic prospects for the U.S. yet clouded by uncertainty surrounding the temporary appropriations and the debt ceiling. Speaking about the Euro zone, there too gloomy clouds of debt-overhang are evident (although bailout packages are doled out and attempts to adopt austerity measures are made) along with political uncertainty, and the entire Euro zone economy has been reporting shrinkage for three successive quarters. In case of some Emerging and Developing Economies (EDEs), including China, are gradually returning to faster growth, activity is slowing in others, hobbled by weak external demand and slack domestic investment. In India, Q3FY13 GDP growth descended further to 4.5% (from 5.3% in the previous quarter) which has been the weakest in the last 15 quarters. What is worrisome is that the services sector growth, hitherto the mainstay of overall growth, has also decelerated to its slowest pace in a decade. While the Index of Industrial Production (IIP) for the month of January 2013 (data release in March 2013) has shown an uptick, the overall trend in industrial activity yet looked ‘see-saw’ with capital goods and mining activity reporting a contraction.
As far as Wholesale Price Index (WPI) inflation in India is concerned, after showing some signs of respite at the beginning of the year 2013, once again inched-up to 6.84% for the month February 2013; although the rise is not very alarming. The up-move in WPI inflation was effected by upward revision in administered prices of petroleum products.
The Inflation bug inches-up
(Source: Office of the Economic Advisor, PersonalFN Research)
But non-food manufacturing inflation, which the central bank uses to gauge demand-driven price pressures, slowed to 3.8% in February 2013 from 4.1% a month ago; brought in some relief. However, an ascending trend in retail inflation with it yet continuing to be in double-digit at 10.9% for the month of February 2013 (led by sustained price pressures from food items, especially cereals and proteins), infused concerns. Thus the divergence between WPI and Consumer Price Index (CPI) inflation has continued to widen during the year.
Speaking about liquidity conditions, it has remained tight over the indicative comfort zone of the Reserve Bank of India (RBI). The reduction in the Cash Reserve ratio (CRR) of banks by 25 basis points, effective from February 9, 2013 and open market purchases of Rs 200 billion since February have enabled money market rates to remain anchored to the policy repo rate. And going forward, the RBI intends to actively manage liquidity through various instruments, including Open Market Operations (OMO), so as to ensure adequate flow of credit to productive sectors of the economy.
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 7.75% to 7.50% (a reduction of 25 basis points (bps) with immediate effect); and
- Reduce reverse repo rate from 6.75% to 6.50%
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 also is thus adjusted to 8.50%, and so is the bank rate to 8.50%
However, since money market rates anchored to policy rates (due to a cut in CRR and open market purchases of Rs 200 billion since February 2013) and the central bank intends to actively manage liquidity through various instruments, including OMOs (so as to ensure adequate flow of credit to productive sectors of the economy), it was decided to keep CRR 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)
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, and the central bank intends to cater to situation as mentioned above.
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:
Notwithstanding moderation in non-food manufactured products inflation, headline inflation is expected to be range-bound around current levels over 2013-14 in view of sectoral demand-supply imbalances, the ongoing corrections in administered prices and their second-round effects. In addition, elevated food prices, including pressures stemming from Minimum Support Price (MSP) increases, and the wedge between wholesale and retail inflation have adverse implications for inflation expectations. Risks on account of the Current Account Deficit (CAD) remain significant notwithstanding likely improvement in Q4 over an expected sharp deterioration in Q3 of 2012-13. Accordingly, even as the policy stance emphasizes addressing the growth risks, the headroom for further monetary easing remains quite limited.
Projections for domestic economic growth and inflation:
Last month 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. While on the domestic front the priority is to reinvigorate growth, the RBI believes the Government has to pay a critical role in accelerating investments for which it has to:
For the domestic economy the risk of spill-over of uncertainty prevailing in the global economy also remains significant.
Speaking about inflation, some softening of global commodity prices and lower pricing power of corporates domestically is moderating non-food manufactured products inflation. However, the unrelenting rise in food inflation is keeping headline wholesale price inflation above the threshold level and consumer price inflation in double digits. Also, there is still some suppressed inflation related to administered prices which carries latent inflationary pressures. All this complicates the task of inflation management and underscores the imperative of addressing supply constraints. From an inflation perspective, upward revisions in the MSP should warrant caution in view of their implications for overall inflation.
What should Debt fund investors do?
The guidance from the monetary policy enunciates that headroom for further monetary easing remains quite limited, and now the while the central bank has appreciated Government’s stance on fiscal consolidation it has also put onus on them in reviving investment sentiments in the country. The Reserve Bank has made it clear that a competitive interest rate is necessary for this, but not sufficient. Sufficiency conditions in view of the Reserve Bank include:
- Bridging the supply constraints;
- Staying the course of fiscal consolidation (both in terms of quantity and quality); and
- Improve governance surrounding project implementation
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. For the fiscal year 2013-14 the government has raised the budget expenditure and will need to borrow Rs 4.84 lakh crore or around 89% of the fiscal deficit from the bond markets. Such high borrowing target may keep the markets under pressure for some time. It is noteworthy that at the time of writing of this article, 15% 2022 (10-Yr) G-Sec yield rose as much as 6 bps to 7.92% from its earlier closing level of 7.86% before TV channels reported the DMK had withdrawn from the ruling coalition.
At present while taking exposure to debt mutual fund schemes and fixed income instruments, one should clearly know their investment time horizon. 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 month, 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 a little more comfortable to look at longer horizon debt mutual funds. Thus, if you have a longer time horizon, then you can now hold some exposure to pure income funds. Since longer tenor papers could 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. One should also be cautious while investing in long term gilt funds, and refrain from speculating in a falling interest rate scenario.
Fixed Maturity Plans (FMPs) of a little over 1 year may be considered for some more time, as double indexation benefit that you may avail can provide you appealing post tax returns. It 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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