Macroeconomic assessment:
Since the second bi-monthly monetary policy was announced in June, global economic recovery has gathered pace. Discontinuing from the fast deceleration, economic activity appeared to be picking up globally. The thrust on loose monetary policy in developed and industrial countries supported the uptick. Despite, uncertainty over the future of supportive monetary policy in the U.S. and amidst the growing geo-political tensions, flow of foreign capital to emerging markets including India remained strong.

On the domestic front, recovery was visible. At USD 26.4 billion in June exports grew at 10.22% in June. There has been a positive impact on the creation of forex reserves in the country. Suggesting buoyancy in manufacturing activity, Index of Industrial Production (IIP) advanced by 4.7%- a 19 month high. In June, industrial outlook survey conducted by RBI had suggested that there were expectations that business activities would pick up in the second quarter (July-September) of the current fiscal. There have been some early signs too. HSBC Manufacturing PMI survey showed that industrial activity has gathered pace in July. Although activities in the service sector appear to be mixed, there have been signs of recovery in corporate earnings.

  Headline inflation

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

After rising in May 2014 to 6.01%, the Wholesale Price Index (WPI) inflation declined to 5.43% in June 2014. The data here revealed that food articles (which have a weightage of 14.34% in WPI) fell to 8.14% in June 2014 as compared to 9.50% in May. Fuel and power inflation (which has weightage of 14.91% in WPI), fell to 9.04% in June 2014 from 10.53% in the month earlier. Inflation in manufacturing growth has increased very mildly due to the lull in industrial activity. The data came in at 3.61% in June 2014 up from 3.55% in May.

The headline CPI inflation has fallen for the two consecutive months. Despite of seasonally high fruits and vegetable prices since March, retail level inflation cooled off. High base effect and deceleration in retail inflation excluding that in the food article and fuel prices pushed the headline retail inflation lower. However, upside risks to CPI inflation still remain which are mainly stemming from possibility of higher crude oil prices due to geo political concerns, continuing uncertainty over monsoon conditions leading to higher food prices and possibility of adverse exchange rate movement in wake of global uncertainties.

Liquidity Situation
With an aim of providing liquidity support, the RBI had reduced Statutory Liquidity Ratio (SLR) to 22.5% of Net Demand and Time Liabilities (NDTL) during the second bi-monthly monetary policy review in June. It was expected that the liquidity enhancement would help in economic recovery.

Liquidity conditions since the bi-monthly monetary policy was announced, has remained stable. To negate the impact of liquidity pressures associated with outflows on account of tax payments and lack of government spending, RBI infused Rs 94,000 crore through 9 special term repos during June and July.

As the Government remains committed to containing fiscal deficit to 4.1% of GDP, banks would face less stress and may lend more to productive sectors of economy, as there is no upside projection to Government borrowing. The RBI believes it is necessary to enhance liquidity in money and debt markets.

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 22.50% to 22.0% of their NDTL with effect from August 09, 2014.
   
• Continue to provide liquidity under 7-day and 14-day term repos at 0.25% 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 22.0% could improve credit flow in the system – especially to productive sectors, and thereby support growth.

Guidance from monetary policy and path for interest rates:

The RBI would continue to monitor developments on the inflation front closely. It is believed that as crude oil prices have started dropping and the outlook for non-crude oil commodities remains moderate. This may have positive impact on inflation in India. The RBI is hopeful that, recent measures taken by the Government on the food management front may aid in correcting supply side constraints however, growing consumer and business confidence is expected to keep demand strong. RBI has stated that, it would take all necessary steps to ensure that inflation cools off.

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%.. 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. Delayed monsoon and its uneven spatial distribution remained serious threats to agriculture production. However, the strong revival in monsoon lately has helped somewhat ease the concerns.

Impact on debt markets...

By and large, market participants were expecting RBI to maintain status quo, mainly given the waggeries of monsoon and uncertainties associated with agricultural production. However, there were some optimistic views too with regards to RBI’s 3rd bi-monthly monetary policy. In absence of easing tensions in Iraq, and falling crude oil prices, 10-year Sovereign benchmark bond had witnessed a considerable drop in yields pre-monetary policy sessions. More or less in line with expectations, RBI maintained status quo. Therefore, there is not much of a reaction from the bond market. Equity markets, initially reacted negatively, however as the day progressed they remained cautiously bullish.

Moreover, RBI’s assurance on addressing liquidity related issues through various mechanisms such as very short term repo may keep

What strategy should debt investors should adopt?

Guidance from monetary policy remains cautiously optimistic. The RBI has been cutting SLR rate which shows that, the RBI wants to ensure that productive sectors get credit assistance. The RBI has given enough clarity on addressing the liquidity related issues which may keep yields on short term maturity papers under check. However, long term papers doesn’t look attractive post monetary policy announcements.

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.
 

Add Comments