Macroeconomic assessment:
Global activity seems to be evolving at a different pace since the 1st bi-monthly monetary policy 2013-14 (held on April 1, 2014), where broad-based strengthening of growth is gaining traction in the U.S. and the U.K. However a noteworthy point is, in the Euro zone, recovery has been struggling to gather momentum. Likewise in the Emerging Market Economies (EMEs), structural constraints continue to impede growth. China's economic growth rate has dwindled and so is India gripped by slowdown. Financial markets across the world still remain vulnerable to news about the impending normalisation of interest rates in some developed economies, even as some valuations appear frothy.
As far as the domestic economy is concerned, sluggishness is yet evident. India's GDP posted a sub-5% growth rate (to be precise 4.7%) in the fiscal 2013-14 and for the last quarter of the fiscal year gone by, 4.6%. The manufacturing activity in the country is pulling down growth. There's been a lull in industrial activity with the Index of Industrial production yet being placed in the negative and reporting dismal growth. You see, the on-going contraction in the production of consumer durables and capital goods, coupled with moderation in corporate sales and non-oil non-gold imports, is indicative of continuing weakness in both consumption and investment demand. Nonetheless, a decisive election results together with improved sentiments is however expected to create conducive environment for comprehensive policy actions and a revival in aggregate demand as well as a gradual recovery of growth during the course of the year.
But at present, the outlook for agriculture is clouded by the Indian Meteorological Department's (IMD's) forecast of a delay in the onset of the south-west monsoon which also faces risk of being below-normal due to 60% chances of occurrence of an El-Nino phenomenon.
Headline inflation
Data as on April 2014
Source: Office of the Economic Advisor, PersonalFN Research)
The chart above depicts that Wholesale Price Index (WPI) inflation is once again showing signs of inching up as the unusual rain and hailstorm experienced in western and northern parts of the country are posing risk to food inflation. Moreover, successive increases in the prices of diesel also infuses risk to fuel and power inflation, and even food inflation; as diesel is an essential transport and industrial fuel.
The retail inflation as measured by the Consumer Price Index (CPI) has increased for the second consecutive month in April 2014 pushed up (to 8.59%) by a sharp spike in food inflation, especially in the prices of fruits, vegetables, sugar, pulses and milk. It is expected that price pressures would continue in May 2014 as well, but it is largely seasonal. The risks to the central forecast of 8.00% CPI inflation by January 2015 remain broadly balanced. Upside risks in the form of a sub-normal / delayed monsoon on account of possible El-Nino effects, geo-political tensions and their impact on fuel prices, and uncertainties surrounding the setting of administered prices appear at this stage to be balanced by the possibility of stronger Government action on food supply and better fiscal consolidation as well as the pass through of recent exchange rate appreciation.
A silver lining though to the gloomy clouds of economic slowdown is that, trade deficit has narrowed down significantly. In the fourth quarter of the fiscal year the merchandise trade deficit contracted by about 33% to U.S. $30.70 billion from U.S. $45.60 billion in the corresponding quarter a year ago. For the entire fiscal year 2013-14 it has fallen to U.S. $147.60 billion from U.S. $195.70 billion in 2012-13. Thus as result, the Current Account Deficit (CAD) is also narrowed to U.S. $32.40 billion (1.7% of GDP) in fiscal year 2013-14 from U.S. $87.80 billion (4.7% of GDP) in the previous fiscal year. Thus on a Balance of Payment (BoP) basis, the foreign exchange reserves of the country has also gone up U.S. $15.50 billion during 2013-14 as compared with U.S. $3.80 billion in 2012-13.
The fiscal deficit of the country for the fiscal year 2013-14 has come in lower at 4.5% as against the budget estimate of 4.8% and revised estimate of 4.6%.
As far as the liquidity situation is concerned, with the unwinding of year-end window dressing, the corresponding decline in the size of excess Cash Reserve Ratio (CRR) holding of banks as well as the sharp decline in Government cash balances with the Reserve Bank (due to Government expenditure); liquidity conditions improved significantly in April and May 2014. The average daily access to liquidity from the LAF and term repos during this period has been close to 1.0% of NDTL.
Monetary Policy Action...
Hence in the backdrop of the aforementioned macroeconomic assessment, it was decided by RBI as under:
- To keep the policy repo rate unchanged 8.00%; and
- To keep the reverse repo rate unchanged at 7.00%
Thereby maintaining the Liquidity Adjustment Facility (LAF) corridor between the repo and reverse repo rate at 100 basis points (bps). Likewise keep the Marginal Standing Facility (MSF) rate and Bank Rate unchanged at 9.00%.
- To keep the CRR of scheduled banks unchanged at 4.00% of net demand and time liability (NDTL).
But...
- Reduce statutory liquidity ratio (SLR) of scheduled commercial banks by 50 bps from 23.00% to 22.50% of their NDTL with effect from the fortnight beginning June 14, 2014;
- Reduce the liquidity under provided under the export credit refinance (ECR) facility from 50.00% of eligible export credit outstanding to 32.00% with immediate effect;
- Introduce special term repo facility of 0.25% of NDTL to compensate fully for the reduction in access to liquidity under the ECR with immediate effect; and
- Continue to provide liquidity under 7-day and 14-day term repos of up to 0.75% of NDTL of the banking system
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 would infer borrowing cost of commercial banks would remain at the same level as earlier. Hence as a reaction to such a move cost of borrowing for individuals and corporates may also remain elevated, thereby keeping home loans and car loans yet expensive.
The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Increasing the repo rate will imply that commercial banks would enjoy the same rate of interest as earlier, for parking their surplus funds with RBI.
The CRR is the amount of liquid cash which the banks are supposed to maintain with RBI. Keeping it unchanged would not infuse further primary liquidity into the banking system. Likewise keeping the MSF rate would not infuse short-term liquidity in the system. But, through the 7-day and 14-day term repos, the RBI has addressed to very short-term liquidity concerns.
The 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. Reducing it by 50 bps to 22.50% could improve credit flow in the system - especially to productive sectors, and thereby support growth.
Reducing the liquidity provided under ECR while introducing special term repo facility of 0.25% of NDTL to compensate fully for the reduction, the RBI has limited access to export credit refinance while compensating fully with a commensurate expansion of the market's access to liquidity. This would also improve the transmission of policy impulses across the interest rate spectrum and engender efficiency in cash/treasury management. It is a measure to move away from sector-specific refinance towards a more generalised provision of system liquidity without preferential access to any particular sector or entity.
Guidance from monetary policy and path for interest rates:
The Reserve Bank's policy stance will be firmly focussed on keeping the economy on a disinflationary glide path that is intended to hit 8.0% CPI inflation by January 2015 and 6.0% by January 2016. If the economy stays on this course, further policy tightening will not be warranted. On the other hand, if disinflation, adjusting for base effects, is faster than currently anticipated, it will provide headroom for an easing of the policy stance.
As far as the liquidity is concerned, the RBI has said it will actively manage liquidity to ensure adequate flow of credit to the productive sectors.
RBI's projection of GDP:
Contingent upon desired inflation outcome, the projection for GDP is retained in the range of 5.0% to 6.0% in 2014-15, evenly balanced around the central estimate of 5.5%. The outlook for the agricultural sector is contingent upon the timely arrival and spread of the monsoon. Easing of domestic supply bottlenecks and progress in the implementation of stalled projects should brighten the outlook for both manufacturing and services. The resumption of export growth is a positive development and as world trade gathers momentum, the prospects for exports should improve further.
Impact on debt markets...
Since markets were expecting the RBI to maintain a status quo in the backdrop of risk emanating from inflationary pressures occurring out delayed / sub-normal monsoon (on account of chance of an El-Nino phenomenon), the benchmark (8.83% 2023 10-Yr G-Sec) yield had risen to 8.70% from 8.65% before the policy announcement. But with a dovish tone in its guidance and after having addressed to credit offtake by lowering SLR, the yield retraced to pre-policy level. The benchmark (8.83% 2023 10-Yr G-Sec) yield also found solace in the fiscal deficit and the CAD data which came in a few days prior to the 2nd bi-monthly monetary policy 2014-15.
What strategy should debt investors should adopt?
The guidance from the monetary policy seems to have a dovish tone. With the RBI saying, if disinflation, adjusting for base effects, is faster than currently anticipated, it will provide headroom for an easing of the policy stance; appears quite accommodative. On inflation, the RBI and the Government seem to on the same page, while it exudes confidence in the new Government in addressing to supply bottlenecks.
Nonetheless, with risk to inflation looming on account of delayed / sub-normal monsoon (which can have an impact on food prices) and successive increases in diesel prices, we are of the view that it would be best to refrain investing in longer maturity debt papers, and instead prefer shorter maturity debt papers, as there's opportunity, at least until inflation is placed on the intended disinflationary guide path as envisaged by the central bank. Given that liquidity will actively manage to ensure adequate flow of credit to the productive sectors, short-term debt papers are expected to do decently.
Hence as compared to longer duration debt funds, funds focused towards shorter end of the maturity curve will continue to benefit over the next few months. Hence in the present scenario, 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 1month, or liquid plus funds for next 3 to 6 months horizon.
Only if permitted by your time horizon and risk appetite if you still want to invest in long-term debt funds, it would be wise to take exposure via dynamic bond funds (as enabled by their mandate they hold debt instruments across maturities). But PersonalFN thinks that given the aforementioned interest rate scenario and macroeconomic variables thereto, one should not hold more than 20% of their debt portfolio in longer tenure funds. 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) can also be considered as an option to bank FDs only if you are willing to hold it till maturity, but one will not get double indexation benefit if invested at present. Alternatively you can also invest in 1 year Fixed Deposits (FDs), as banks are offering interest on 1 year FDs in the range of 8.00% - 9.00% p.a.
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