In recent times there's been a slowdown in global economic activity and risks has been elevated due to uncertainty over policies of systemic central banks. While in the U.S. signs of economic vigour are evident, the Federal Reserve has said they may wind down the monthly $85-billion bond-buying programme and are mapping out a strategy thereto. In fact the rise in yields of U.S. 10-year T-bills is indicating that the U.S.'s quantitative easing programme is at the end of the horizon. As far the Euro zone is concerned, there's been a contraction in economic growth rate and double-digit unemployment rate. In the Emerging and Developing Economies (EDEs) on the other hand, growth has been rather resilient, although in some large emerging economies, sluggish external demand and stalled domestic investment are dragging down economic activity.

Speaking specifically about India, the macroeconomic conditions remain weak, hamstrung by infrastructure bottlenecks, supply constraints, lacklustre domestic demand and subdued investment sentiment. As many of you may be aware that India has been seeing a descending trend in economic growth in the last couple of years and even now in the current financial year, the industrial activity hasn't been any encouraging (with Index of Industrial Production (IIP) having decelerated to 2.3% in April 2013). Fortunately, headline WPI inflation has eased for three month is succession and has moderated with reading for May 2013 at 4.70%, down from an average of 7.37% in 2012-13.

  WPI Inflation mellowed down further

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

 

Still elevated food inflation, particularly in respect of cereals and vegetables, sustained upside pressures on overall inflation. Likewise, retail inflation (as measured by the Consumer Price Index (CPI) inflation has ebbed to 9.31% in May 2013 from average of 10.20% in in the last fiscal year. But, the recent depreciation in the Indian rupee against the U.S. dollar - where it has fallen 6.6% during May 22, 2013 to June 11, 2013 due to sell-off by Foreign Institutional Investors (FIIs), reflecting risk-off sentiment triggered by apprehensions of possible tapering off of quantitative easing by the U.S. Federal Reserve; has inflicted new worries amid widening Current Account Deficit (CAD). So for inflation, the upside pressure emanating from rupee depreciation, recent increases in administered prices and persisting imbalances - especially relating to food; pose a risk.

Speaking about liquidity conditions, the net average daily borrowings under the Liquidity Adjustment Facility (LAF) have declined gradually, from Rs 1.2 trillion in March 2013 to Rs 0.7 trillion in June 2013 so far (up to June 14, 2013), reflecting the sizable injection of primary liquidity through the reduction in the cash reserve ratio (CRR) in January 2013 and Open Market Operations (OMO) purchases during Q4 of 2012-13.

Monetary Policy Action...
Thus in the background of the aforementioned macroeconomic situation and to balance of risks between growth and inflation on the domestic front, it was decided by RBI as under:
 

• To keep the repo rate unchanged at 7.25%; and
   
• To keep the reverse repo rate unchanged at 6.25%
   

Thereby, maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis. Also the Marginal Standing Facility (MSF) rate, determined with a spread of 100 basis points above the repo rate also is maintained at 8.25%, and so is the bank rate to 8.25%.

However, since CRR was already reduced by 200 bps since January 2012 to infuse liquidity and active management of liquidity vide Open Market Operations (OMOs) have also taken place, the CRR was kept unchanged at the current level of 4.0%.

  Policy rate tracker

	Increase / (Decrease) since FY12-13	At present
Repo Rate	(125 bps)	7.25%
Reverse Repo Rate	(125 bps)	6.25%
Cash Reserve Ratio	(75 bps)	4.00%
Statutory Liquidity Ratio	(100 bps)	23.00%
Bank Rate	(125 bps)	8.25%

Data as on June 17, 2013
(Source: RBI, 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 would infer, borrowing cost of commercial banks may remain same. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may also not ease thereby home loans and car loans being available at the same rate as present.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Keeping it unchanged will imply that commercial banks would fetch the same interest rate as they are receiving at present, 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, with not infuse further primary liquidity into the banking 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:

The Reserve Bank's monetary policy stance will be determined by how growth and inflation trajectories and the balance of payments situation evolve in the months ahead. It is only a durable receding of inflation that will open up the space for monetary policy to continue to address risks to growth. While several measures have been taken to contain the current account deficit, we need to be vigilant about the global uncertainty, the rapid shift in risk perceptions and its impact on capital flows. The Reserve Bank stands ready to use all available instruments and measures to respond rapidly and appropriately to any adverse developments.

Outlook on domestic economic growth, inflation and CAD:

The RBI is hopeful that, last year's robust rabi production and the monsoon performance so far augur well for growth prospects. But the spatial and temporal distribution of rainfall over the next three months will be crucial in determining the performance of agriculture. As far as manufacturing activity is concerned, the continuing weakness needs to be reversed. According to RBI the key to reinvigorate growth is accelerating investment by creating a conducive environment for private investment, improving project clearance and implementation and leveraging on the crowding-in role of public investment.

On inflation, the easing commodity prices at the global level and weaker pricing power of corporates at the domestic level are having a softening influence. Given that food inflation remains high, the inflation outlook will be influenced by concerted efforts to break food inflation persistence. The inflation outlook going forward will be determined by suppressed inflation being released through revisions in administered prices, including the minimum support prices (MSP) as well as the recent depreciation of the rupee.

As far as CAD is concerned, the RBI is of the view that softer global commodity prices and recent measures to dampen gold imports are expected to moderate the CAD in 2013-14 from its level last year. While the main challenge is to reduce CAD to a sustainable level; the near-term challenge is to finance it through stable flows.

What strategy should debt investors should adopt?

The guidance from the monetary policy enunciates that monetary policy stance will be determined by how growth and inflation trajectories and the balance of payments situation evolve in the months ahead.

It is noteworthy that debt fund managers are significantly lowering their exposure of G-Secs from bond and income funds after the central bank introduced the new 10-year bond maturing in 2023 at a coupon rate of 7.16%. Moreover, now that yield therein has risen to 7.32% amid worry over widening CAD and weak rupee, cautiousness seems to be prevailing. Thus ascertaining the risk-reward relationship in the present interest rate scenario, debt fund managers are preferring shorter maturity papers. On the other hand, the rally in G-Secs - the old 8.15% 10-Yr G-Sec has been rather strong with a 75 bps reduction in policy rates thus far in calendar year 2013.

PersonalFN is of the view that, it would be best to refrain investing in longer maturity debt papers in the aforesaid backdrop, and instead prefer shorter maturity debt papers. In case if one wishes to take exposure to longer duration instruments or debt mutual fund schemes holding longer maturity papers (as permitted by their high risk appetite), PersonalFN recommends that you do so by investing in dynamic bond funds, since there would always be intermediate interest rate risk involved.

In the current scenario while investing in debt instrument, 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 1½ months, or liquid plus funds for next 3 to 6 months horizon. If you as an investor have a short to medium term investment horizon (of 1 to 2 years), you may allocate a part of your investment to short-term income funds, provided that you are willing to take some interest rate risk. 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) of 3 months to 1 year period 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 7.50% - 8.75% p.a.

 

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