Taking into account the several significant developments which have emerged since the last monetary policy review meet (held on July 31, 2012), the Reserve Bank of India (RBI) took congruent stance in its 2nd quarter mid-review of monetary policy 2012-13.

With liquidity being infused in the global economy with bond-buying programs in by the European Commercial Bank (ECB) and by the U.S. Federal Reserve through purchase of additional agency mortgage-backed securities (until labour market conditions improve substantially) and extension of exceptional policy accommodation until mid-2015; there has been liquidity infusion which has invited a period of “risk-on” in the global economy, although attempts are made to put short-term worries to rest and show consideration towards economic growth. Moreover, this risk mitigation measure is putting pressure on global asset prices, and particularly commodities prices.

In the domestic economy, growth continues to be weak amidst a negative investment climate, but in the recent past FDI announcement and deferment of GAAR by the Government have enabled in reversing investment sentiments. Likewise there also seems to be a focus on the path to fiscal consolidation (since fuel subsidies having been reduced and announcement of sale stake in public companies is made). Thus in the backdrop of this, there seems to be favourable growth-inflation dynamic by initiating a shift in expenditure away from consumption (subsidies) and towards investment (through FDI increase). Of course, several challenges remain, one of which is persistent inflation. But, as policy actions to stimulate growth and infuse short-term liquidity while being focused about inflation management it has been decided to:
 

• Reduce the Cash Reserve Ratio (CRR) of scheduled banks by 25 basis points (bps) (i.e. from 4.75% to 4.50%) with effect from September 22, 2012
   

But keep policy rates unchanged as under:
 

• Repo rate at 8.00%; and
   
• Reverse repo rate at 7.00%
   

Thereby, maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis points. Also the Marginal Standing Facility (MSF) rate, determined with a spread of 100 basis points above the repo rate stands unchanged at 9.0%. Likewise the Bank Rate was also left untouched at 9.0%
 

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	(25 bps)	4.50%
Statutory Liquidity Ratio	(100 bps)	23.00%
Bank Rate	(50 bps)	9.00%

(Source: RBI, PersonalFN Research)  

The 25 bps reduction in CRR is expected to consequentially inject around Rs 17,000 crore of primary liquidity into the banking system; which we believe could increase credit growth and may also enable banks to reduce borrowing rates ahead of festive season, thereby help in bolstering industry growth.

  The Inflation bug!

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

 

Although, the diesel prices have been increased by Rs 5, and rationalisation of subsidy for LPG is initiated by the Government, the central bank believes that stickiness in headline WPI inflation is likely to remain due to demand-supply imbalances in protein rich (food) items and vulnerability of international crude oil prices due to global liquidity. Moreover, with manufactured goods inflation inching up (moved from 5.1% in April 2012 to 5.6% in August 2012), the momentum indicator remains elevated. Thus containing inflationary pressures and lowering inflation expectations warrant maintaining the momentum of recent policy actions to step up investment, alleviate supply constraints, and improve productivity.

As far as the liquidity condition is concerned, liquidity has remained quite comfortable since the 1st quarter review of monetary policy 2012-13. However, going forward, the wedge between deposit growth and credit growth could widen on the back of the seasonal pick-up in credit demand in the second half of the year. Moreover, the advance tax payment obligations and the onset of festival-related currency demand, could accentuate pressures on liquidity over the next few weeks; and therefore the central bank has reduced CRR in order to address to this issue and facilitate credit to the productive sectors of the economy.

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 not change significantly, although commercial banks in the country may like to reduce lending rates ahead of the festive season, and since it is well supported by the liquidity infusion due to a CRR cut.

Similarly, the interest rates on fixed deposits could reduce. In fact recently some banks have already reduced interest rates on fixed deposits, and at present 1-yr FDs (Fixed Deposits) are offering interest in the range of 7.25% - 9.00% 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 amount of liquid cash which the banks are supposed to maintain with RBI. Reducing the same, as said above would infuse short-term liquidity in the system.

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 it unchanged at the last reduced level of 23.00% could improve credit flow in the system – especially to productive sectors, and thereby support growth.

Guidance from monetary policy and path for interest rates:

Since the 1st quarter review of monetary policy 2012-13, growth risks have increased, but inflation risks still persists. While monetary policy has an important role in supporting the growth revival, it is perceived by the RBI that inflationary pressures persists along with risk from twin deficits i.e. current account deficit and fiscal deficit, which are constraining a stronger response of monetary policy to growth risks. Thus as this process evolves, the stance of monetary policy will be conditioned by careful and continuous monitoring of the evolving growth-inflation dynamics, management of liquidity conditions to ensure adequate flows of credit to productive sectors and appropriate responses to shocks emanating from external developments.

What should Debt fund investors do?

Looking at the growth-inflation dynamics, interest rates are likely to hover around the present elevated levels, until signs are moderation in WPI inflation are evident.

Hence at present while taking exposure to debt mutual funds and fixed income instruments, one should clearly know their investment time horizon. 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 months 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 may for some more time 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 further. At present 1 year FDs are offering interest in the range of 7.25% - 9.00% p.a.

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