The Reserve Bank of India (RBI) increased its key policy rates as the domestic economic recovery is on a strong footing (GDP growth rate at 8.8% for Q1 of fiscal year 2010-11) despite fragile global economic recovery.

 

The steps taken by the central bank in the second quarter review of monetary policy 2010-11 are:

 

The Repo rate has been increased by 25 basis points, from 6.00% to 6.25% and

 

The Reverse Repo rate too has been increased by 25 basis points, from 5.00% to 5.25%

 

Thus maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis points.

 

However, the Cash Reserve Ratio (CRR) is kept unchanged at 6.00%, %, taking into account the tight liquidity situation.

 

(Personal FN’s expectation was a 25 basis points increase, each in repo and reverse repo rate, thus placing them at 6.25% and 5.25% respectively. We forecasted CRR to remain unchanged at 6.00%.)

 

The other highlights of the monetary policy are as follows:

 

• Bank rate left unchanged at 6.00%.


• Statutory Liquidity Ratio (SLR) has been left unchanged at 25.00%: SLR is that amount which a bank has to maintain in the form of cash, gold or approved securities. The quantum is specified in terms of percentage of the total demand and time liabilities of a bank.

 

Reason for the rate hike:

A stiff Inflationary pressure was major concern for the central bank to adopt this calibrated exit path in the monetary policy, as demand sides as well as supply side inflation are at play. Also given the spread and persistency of inflation, the need for demand side pressures was felt to be controlled.

 

The WPI (Wholesale Price Index) inflation for September 2010 (after mellowing down to 8.51% in August 2010), once again commenced its northward journey to 8.62%. Earlier the Finance Minister, Mr. Pranab Mukherjee had also expressed his concern over the rising prices by saying; managing inflation has been one of his biggest challenges. The RBI Deputy Governor – Mr. Subir Gokarn had also reiterated that “inflation was uncomfortably high”.

 

(Source: Reuters website, PersonalFN)

 

Moreover, food inflation (13.75% for the week ended October 16, 2010) not moderating post-monsoon, also prompted the RBI to increase policy rates, thus ensuring that high prices of food items do not get spilled to other commodities.

 

But nonetheless, taking into account the progress of monsoon, (which improves the chance of good harvest), and domestic macroeconomic scenario, the RBI expects headline WPI inflation to settle down to 5.50% (as per new series 2004-05) by March 2011 (Forecasted inflation range given by the Finance Ministry is 5.00% to 6.00% by March 2011).

 

(Personal FN’s forecast for inflation range is 6.50% - 7.00% by fiscal year end)

 

We think that, core inflation will continue to exist as the Indian economy continues to trail the growth path.

 

The policy rate action taken by RBI, despite liquidity deficit is said to be prudent because excessive deficit will not do good for financial markets and credit growth in the banking system. Moreover, strong economic recovery in the domestic market also encouraged the central to take this move, despite talks of a fragile economic recovery in the global environment. Hence, against this backdrop, the stance of the monetary policy is intended to:

 

• Contain inflation and anchor inflationary expectations, while being prepared to respond to any further build-up of inflationary pressures
• Maintain an interest rate regime consistent with price, output and financial stability
• Actively manage liquidity to ensure that it remains broadly in balance, with neither a surplus diluting monetary transmission nor a deficit choking off fund flows

 

On the second quarter review of monetary policy, Deputy Chairman of the Planning commission – Mr. Montek Singh Ahluwalia exuded confidence saying, “the move was a perfect balance between managing inflation and promoting growth”.

 

What does the rate hike mean and its impact?

 

The repo rate is the rate of interest charged by the central bank on borrowings by the commercial banks. A hike in the same means, an increased cost of borrowings for commercial banks. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may become expensive, as the lending rates might move marginally upwards, post the festive season of Diwali.

 

Similarly, the interest rates on fixed deposits are also expected to start firming up, as banks will try to manage tight liquidity situation. At present 1 yr FDs (Fixed Deposits) are offering interest in the range of 6.50% - 7.25% p.a.

 

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. A hike in the same means, it will be more attractive for commercial banks to park their surplus funds with RBI, thus enabling the central bank to manage excess liquidity.

 

GDP estimate: RBI has kept its GDP growth estimated unchanged at 8.50% for the fiscal year 2010-11 (as forecasted in Q1 review of monetary policy held on July 27, 2010), taking into account the following factors:

 

• Good monsoons and thus progress in the agriculture sector
• Indicators of industrial production and service sector activity
• Prevailing global economic scenario

 

What should Debt fund investors do?

 

The central bank has clearly said that, “Going forward, the growth-inflation outlook will dominate the policy response,” and has also added that "headline inflation... continues to be a cause of policy concern and priority.”. Hence, given that we are in still in a rising interest rate scenario, for you debt mutual funds are not the ideal investment, as bond price and interest rates are inversely related to each other. In the current scenario, you are recommended to stay away from long term income and government securities funds till RBI’s next mid-quarter monetary policy review meeting schedule for December 16, 2010.

 

Hence, if you have a short-term time horizon (of less than 3 months) you would be better off investing in liquid for the next 1 ½ month or liquid plus funds with a 3 to 6 months horizon; while if you have a medium term investment horizon (of over 6 months), you may allocate your investments to floating rate funds. Short term income funds should be held strictly with a 1 year time horizon. At present we do not expect any major increase in the rates of short term instruments. 3 months and 1 Year Certificate of Deposits (CDs) are at 7.50% and 7.90% respectively, and are already factoring tight liquidity situation along with high interest rates. This is because the markets had already factored in 25 basis points increase in the policy rates (both repo as well as the reverse repo).

 

You can also consider investing your money in Fixed Deposits (FDs). At present 1 yr FDs are offering interest in the range of 6.50% - 7.25% p.a.

 

What to expect in the near future?

 

We believe that RBI will continue adopting the calibrated exit path by increasing policy rates by 25 basis points if inflation still continues to climb, provided growth is intact. But a noteworthy point here is this was the sixth consecutive hike in policy rates, where so far both repo and reverse repo rates have been increased by 125 basis points and 175 basis points respectively. Hence, taking this into account, the intermediate rate hike (in the next mid-quarter review of monetary policy scheduled for December 16, 2010) looks unlikely.

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