With the overcast of a debt-overhang in the Euro zone engulfing a sense of turmoil across the global economy and sending negative ripples (which have deepened since the Annual Monetary Statement in April 2012), the Reserve Bank of India (RBI) refrained from reducing policy rates despite a slump in domestic economic growth rate, and dismal industrial activity.
 

The Inflation bug!

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

The headline Wholesale Price Index (WPI) inflation precluded the central bank to take even a muted stance as the data for May 2012 (reported at 7.55%), remained over the comfort zone (of 6.0% to 7.0%) of RBI. With food inflation placed at 10.74% in May 2012 (as against 10.49% in the previous month), worrisome signals were sent, which elevated due to sluggish progress of monsoon and expectation of "El-Nino" phenomenon developing in August 2012. Likewise although the fuel prices did fall significantly, the depreciation of the Indian rupee against the U.S. dollar offset the impact, and thus fuel inflation (in WPI) was also placed at 11.53% for May 2012.

Similarly, Consumer Price Index (CPI) inflation (as measured by the new series, base year 2010) depicted an ascending trend as it rose from 8.8% in February to 9.4% in March and further to 10.4% in April. This thus made it evident that moderation was not transmitted to the retail level.

As far as the liquidity condition is concerned, the wedge between the deposit growth and credit growth suggested intensifying liquidity situation. But the Open Market Operations (OMOs) have helped to ease the liquidity conditions as it was reflected by stabilization of overnight call money rate (8.06%) close to the policy repo rate (of 8.0%). To further augment liquidity and encourage banks to increase credit flow to the export sector, the Reserve Bank has increased the limit of export credit refinance from 15% of outstanding export credit of banks to 50%, which will potentially release additionally liquidity of over Rs 300 billion, equivalent to about 50 basis points (bps) reduction in the CRR.

Monetary Policy action...
Thus on the basis of an assessment of the aforementioned economic factors, it was decided to:
 

• Keep the repo rate unchanged at 8.00%; and
   
• Keep the reverse repo rate unchanged at 7.00%
   

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

Moreover, since liquidity infusion due to increase in limit of export credit refinance to 50% (from 15%); which had an equivalent impact of 50 bps reduction in CRR it was decided to keep the CRR unchanged at 4.75%. Likewise Marginal Standing Facility (MSF) and bank rate was also left untouched at 9.0%.

Similarly, the Statutory Liquidity Ratio (SLR) has been kept unchanged at its last reduced level of 24% (In the third quarter mid-review of monetary policy 2010-11 on December 16, 2010, SLR was reduced from 25% to 24%).
  Policy rate tracker

	Increase / (Decrease) in FY12-13	At present
Repo Rate	(50 bps)	8.00%
Reverse Repo Rate	(50 bps)	7.00%
Cash Reserve Ratio	Unchanged	4.75%
Statutory Liquidity Ratio	Unchanged	24.00%
Bank Rate	(50 bps)	9.00%

(Source: RBI website, 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. Keeping it unchanged means, borrowing cost of commercial banks would remain unchanged. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may still remain stiff, as the commercial banks in the country would refrain from lending at cheaper rates, and this in turn may continue to put pressure on economic activity in the country. However, just last week, the country largest lender State Bank of India has slashed lending rates by 50 to 350 bps across categories.

Similarly, the interest rates on fixed deposits are expected to remain unchanged. At present 1-yr FDs (Fixed Deposits) are offering interest in the range of 7.25% - 9.25% p.a.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Keeping them unchanged will result in commercial banks fetching the same interest rate, as what they are receiving so far, 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 at the last reduced level of 4.75% may provide comfort to the liquidity situation (due to increase in limit of export credit refinance to 50% from 15%; which has an equivalent impact of 50 bps reduction in CRR).

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 them unchanged would not hurt the liquidity situation.

Guidance from monetary policy and path for interest rates:

The evolving growth-inflation dynamic will continue to influence the Reserve Bank's stance on interest rates. Since, both headline and retail inflation rates are rising, they have a bearing on inflation expectations. Thus future policy actions will depend on continuing assessment of external and domestic developments that contribute to lowering inflation risks.

Liquidity management also remains a priority. At present although liquidity situation converges to the comfort zone, the central bank will continue to use OMOs as and when warranted to contain liquidity pressures. Also, recognising that global economic situation is turbulent the RBI stands ready to use all available instruments and measures to respond rapidly and appropriately to any adverse developments.

What should Debt fund investors do?

At present while taking exposure to debt mutual funds and fixed income instruments, one should clearly know their investment time horizon. The current liquidity infusion of around Rs 300 billion may mellow down the short-term interest rates going forward. Hence 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 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 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 will 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.

Fixed Maturity Plans (FMPs) of upto 1 year would continue to yield appealing returns and 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. At present 1 year FDs are offering interest in the range of 7.25% - 9.25% p.a.

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