RBI keeps vigil on inflation. Keeps policy rates unchanged!
Apr 01, 2014

Author: PersonalFN Content & Research Team

Macroeconomic assessment:
Global activity seems to have moderated since the 3rd quarter review of monetary policy 2013-14 (held on January 28, 2014), where slower growth has been reported by the developed economies such as the U.S. and the U.K. Likewise, the emerging and developing economies have witnessed a subdued pick-up restrained by the uncertain external demand environment as well as by localised cyclical and structural constraints. Also for a number of emerging markets, further tightening of external financing conditions and renewed volatility of capital flows are the biggest risks to their outlook.

As far as the domestic economy is concerned, GDP growth rate has been modest with some strengthening of activity in services such as trade, hotels, transport and communication, and financing, real estate and business services. But despite some positives, the industrial activity has been witnessing a lull and continues to be a drag for the domestic economy, with weakness in consumption and investment demand. In the quarters ahead, the boost provided by robust agricultural production in 2013 may wane. This is because the outlook for 2014 southwest monsoon remains uncertain with chances of an El-Nino phenomenon. Moreover, the unseasonal rains along with hailstorms may turn to damaging for overall crop produce.

Headline inflation
WPI inflation

Data as on February 2014
Source: Office of the Economic Advisor, PersonalFN Research)

Since December 2013 sharper than expected disinflation in vegetable prices has enabled a sizable fall in headline inflation. But going forward, due to probability of a less-than-normal rainfall in 2014 (due to El-Nino phenomenon), which will bring in uncertainty in setting minimum support prices for agricultural commodities and other administered prices, especially of fuel (which is an essential transport fuel impacting food prices), fertilisers and electricity; it could exert upward pressure on food inflation. While retail inflation as measured by CPI inflation has mellowed for the third month in succession in February 2014 driven by sharp disinflation in food prices, the prices of fruits, milk and products have started to firm up. Moreover, excluding food and fuel retail inflation has remained sticky at around 8.0%. This suggests that some demand pressures are still at play.

A silver lining though to the gloomy clouds of economic slowdown is that, trade deficit has narrowed down significantly. The merchandise trade deficit was 22.0% in April-February 2013-14 than its level a year ago, due to the large decline in non-oil imports. Therefore now the Current Account Deficit (CAD) is expected to be about 2.0% of GDP for the year 2013-14 as compared with 4.8% in 2012-13. Most recently, however, export growth has slowed, partly because of slowdown in demand in partner countries as well as a softening of prices of exports of petroleum products and gems and jewellery (offset by a reduction in the prices of oil and gold imports).

As far as the liquidity situation is concerned, envisaging pressures from large currency demand and tax outflows from mid-March, the central bank managed the liquidity situation actively through repo auctions. A 21-day term repo of Rs 500 billion was conducted on March 14 and 7-day term repo auctions of Rs100 billion on March 19 and 26, in addition to the regular 14-day term repo of Rs 400 billion on March 21. Moreover, a 5-day term repo for a notified amount of Rs 200 billion was conducted on March 28 to facilitate non-disruptive banking operations during the annual closing of accounts. Going forward too, the central bank has said it will continue to monitor the liquidity conditions and actively manage liquidity to ensure adequate flow of credit to the productive sectors.

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 cash reserve ratio (CRR) of scheduled banks unchanged at 4.00% of net demand and time liability (NDTL).
But...

Increase the liquidity provided under 7-day and 14-day term repos from 0.5% of NDTL of the banking system to 0.75%, and decrease the liquidity provided under overnight repos under the LAF from 0.5% of bank-wise NDTL to 0.25% with immediate effect.

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 Cash Reserve Ratio 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.

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. Therefore at the current juncture, it was felt appropriate to hold the policy rate, while allowing the rate increases undertaken during September 2013-January 2014 to work their way through the economy. Furthermore, if inflation continues along the intended glide path, further policy tightening in the near term is not anticipated at this juncture.

RBI’s projection of GDP:
Contingent upon desired inflation outcome, real GDP growth is projected to pick up from a little below 5.0% in 2013-14 to a range of 5.0% to 6.0% in 2014-15 albeit with downside risks to the central estimate of 5.5%. Lead indicators do not point to any sustained revival in industry and services as yet, and the outlook for the agricultural sector is contingent upon the timely arrival and spread of the monsoon. Easing of domestic supply bottlenecks and progress on the implementation of stalled projects already cleared should brighten up the growth outlook, as would stronger anticipated export growth as the world economy picks up.

Impact on debt markets...

Since markets were expecting the RBI to maintain a status quo in the backdrop of mellow down in headline inflation, retail inflation and lower trade deficit; the yields at the longer end of the yield curve were not affected by RBI’s monetary policy action. However, with very short-term liquidity concerns having addressed to through term repos and fiscal year end bond buybacks and usage of MSF window, the short-term rates mellowed down a bit.

But with the fiscal deficit at the end of first 11 months of the financial year 2013-14 having come sharply higher at 114.3% of the revised estimates, it is likely that the longer end of the yield curve could inch-up, as it indicates that the ambitious fiscal deficit target of 4.6% could be breached. It is noteworthy that, global rating agencies have already signalled that India’s fiscal deficit situation remains weak and if does not improve, the country’s sovereign rating could be downgraded.

Thus, the longer end of the yield curve seems to be exposed to more risk than the shorter end.

What strategy should debt investors should adopt?

So in the aforesaid backdrop, PersonalFN is 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. This will in turn advance the Yield to Maturity (YTM) of mutual funds holding money market instruments like CD and CP in their portfolio. 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. 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 .