In recent times, the outlook for global growth has remained moderate. The warning from the European Union (EU) saying that the Euro zone crises are not yet over, kept the markets nervous. It is noteworthy that, while the Euro zone has emerged from a recession lasting six quarters early this year, it struggled to gain momentum due weak domestic demand and a challenging environment for exporters. A similar situation is being witnessed by most of the emerging market economies (EMEs) which are witnessing a weak domestic demand notwithstanding some improvement in the export performance. The financial markets are concerned about the downbeat factors and the news disseminating regarding the inevitable tapering of stimulus by the Federal Reserve in the U.S.

Speaking about India, while we have undergone a slowdown which is distinctly evident vide dwindling quarter-on-quarter (Q-O-Q) GDP growth rate and lull in industrial activity; the strengthening export growth and signs of revival in some services, along with expected pick-up in agriculture, could support and increase in growth in the second-half of the present fiscal year 2013-14; thereby raising real GDP growth rate from 4.8% in Q2FY14 to a central estimate of 5.0% for the whole fiscal year. The revival of large stalled projects and the pipeline cleared by the Cabinet Committee on Investment may buoy investment and overall activity towards the close of fiscal year.
 

WPI Inflation inches-up again!

Data as on November 2013
Source: Office of the Economic Advisor, PersonalFN Research)  

The WPI inflation has been on a rise since the last few months thereby making it obvious that inflationary pressures are creeping in and disturbing the moderation which was evident a few months ago. As far as CPI inflation is concerned, it has mounted to the double digit terrain due to the increase in vegetable prices, housing inflation and elevated levels of inflation in the non-food and non-fuel categories. Although the vegetable prices seem to adjust downwards in certain areas, the reduction in the too high CPI inflation is yet to be seen. There have also been signs of resumption of high rural wage growth, suggesting second round effects that cannot be ignored.

As far as the Current Account Deficit (CAD) is concerned, the improvement in performance of exports over the last couple of months along with contraction in oil and non-oil import demand has enabled a perceptible narrowing of trade deficit, which has shown favourable implications for CAD. Policy interventions and robust inflows into the swap windows have bridged the external financing gap. These factors have brought some calm to the foreign exchange market. According to RBI, these favorable developments should help to build resilience to external shocks.

Speaking about liquidity situation, the liquidity conditions have improved, as reflected in the steady decline in the access to the MSF. Anticipating the temporary tightness in liquidity starting from mid-December 2013 on account of advance tax payments, the Reserve Bank conducted additional 14-day term repo auction of Rs 100 billion on December 13, augmenting the normal access to liquidity from the Reserve Bank to the tune of 1.5% of NDTL (i.e. about Rs 1.2 trillion) under overnight repos, term repos, and the export credit refinance facility. The Reserve Bank also opened a refinance facility of Rs 50 billion for the Small Industries Development Bank of India (SIDBI) aimed at addressing liquidity stress faced by medium, micro and small enterprises. Liquidity is being managed with a view to ensuring that there is adequate credit flow to the productive sectors of the economy.

The RBI is of the view that there are indications that vegetable prices may be turning down sharply, although trading mark-ups could impede the full pass-through into retail inflation. In addition, the disinflationary impact of recent exchange rate stability should play out into prices. Finally, the negative output gap, including the recent observed slowdown in services growth, as well as the lagged effects of effective monetary tightening since July, should help contain inflation. Hence the RBI believes that although that the high level of CPI inflation excluding food and fuel leaves no room for complacency, there is reason to wait before determining the course of monetary policy.

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 under the liquidity adjustment facility (LAF) unchanged at 7.75%; and
   
• To keep the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand and time liability (NDTL).
   

Consequently, the reverse repo rate under the Liquidity Adjustment Facility (LAF) will remain unchanged at 6.75%, and the marginal standing facility (MSF) rate and the Bank Rate at 8.75%.

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 to the last level would infer, borrowing cost of commercial banks will remain the same as at present. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may remain elevated, thereby making home loans and car loans expensive.

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 were receiving in the past, 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.

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 help credit flow in the system - especially to productive sectors, which could be address growth risk.

Guidance from monetary policy and path for interest rates:

The Reserve Bank has made it clear that although it has maintained status quo by keeping the policy rates unchanged, it can help guide market expectations through a clearer description of its policy reaction function. Hence if the expected softening of food inflation does not materialise and translate into a significant reduction in headline inflation in the next round of data releases, or if inflation excluding food and fuel does not fall, the Reserve Bank will act, including on off-policy dates if warranted (so that inflation expectations stabilise and environment conducive to sustainable growth takes hold). RBI had clarified previously that no single data point would decide the course of policy action; it preferred to await some more clarity on various macro-economic indicators.

Impact on debt markets...

Since markets were expecting a rate hike following higher WPI and CPI inflation and higher fiscal deficit; a rate hike of 25bps (or 0.25%) appeared imminent and was factored in. However, as policy rates have been kept unchanged, markets may witness a relief rally. The growth still remains a concern and new capex cycle looks weak. The fiscal deficit has already exhausted 84% of its limit set for the Financial Year (FY) 2013-14. Higher deficit would put pressure on bond yields. PersonalFN is of the view that investors would be better-off avoiding any speculation pertaining to interest rate movement. We believe that one shouldn't invest more than 20% of one's portfolio in long term debt funds. Going forward, the shorter end of the yield curve appears to be more beneficial than the long end of the yield curve.

What strategy should debt investors should adopt?

The guidance from monetary policy has made it clear that the Reserve Bank will remain vigilant and inflation would remain under focus while being mindful of the growth dynamics. With liquidity concerns having addressed with the steps thereto taken in the recent past, shorter maturity papers would see softening in yields. But at the longer end of the yield curve, pressures may be felt and thus yields of longer maturity papers may remain under pressure with macroeconomic concerns on inflation, fiscal deficit and sovereign rating.

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. 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) 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 8.00% - 9.00% p.a. 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.

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