RBI touches a tipping point in managing growth- inflation dynamic
Jan 29, 2013

Author: PersonalFN Content & Research Team

In the year 2013 thus far, the headwinds holding back the global economy have begun to abate gradually, while sluggish conditions yet remain. In the U.S. with the fiscal deal being averted with the passage of the U.S. fiscal deal, confidence has imbued and their Q3 growth rate too has gathered momentum (3.1% in Q3 from 1.3% in Q2). But going forward in Q4, the sustainability of such growth rate remains under question, given the increasing debts of the U.S. Speaking about the Euro zone, although intermediate worries have receded with a bailout package for Greece doled out and restructuring of loans permitted for Spanish banks, the long-term risk yet remain. In fact the complete Euro zone is yet witnessing a contraction (Q2 GDP growth rate at -0.1%) despite liquidity firewall provided by the European Central Bank (ECB). Among the Emerging and Developing Economies (EDEs), China is showing signs of better economic recovery with better manufacturing data (HSBC China manufacturing Purchasing Managers' Index rose to a final reading of 51.5, an upward revision from the preliminary 50.9 result) being reported due to news business flows and thus pick-up in economic growth in imminent for the nation. But it is noteworthy that a recovery China could inflict some inflationary pressures on India as well since commodity prices may stoke-up.

At present for India, Wholesale Price Index (WPI) inflation led by non-food manufactured products inflation has softened through Q3 of our fiscal year providing some relief from the persistence that dominated the first half of the year. It is noteworthy that at present overall WPI inflation too has softened to 7.2% in December 2012 (from 8.1 in September 2012).

The Inflation bug mellowed down

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

However since food inflation remains elevated Consumer Price Index (CPI) inflation now remains under pressure. Going forward in 2013-14 moderation in food inflation is likely to be muted as the correction of under-pricing of administered items is still incomplete and food inflation remains elevated. It is noteworthy that, in food inflation significant price pressures emanated from cereals. Prices of pulses and other protein-based food items too remained elevated. Furthermore, with the firming up of prices of edible oils and grain mill products, the overall momentum in food inflation remains firm. Also the staggered increase in diesel prices announced earlier this month is likely to percolate through to overall costs and inflation; but this would dissipate over a period of time.

As far as economic growth is concerned, it has remained sluggish (Q2FY13 GDP growth at 5.3%). Index of Industrial Production (IIP) too has depicted a "see-saw" movement, although series of measures have been taken by the Government to boost the outlook. But going forward, since manufacturing PMI rose in December 2012 (on the back of higher order book volumes and new export orders) and services PMI too has risen (on expectations of a revival of demand), respite to industrial output numbers is expected going forward.

Speaking about liquidity conditions, it tightened from the second week of November 2012 on account of a build-up in the Centre's cash balances, festival-related lumpy increase in currency demand, and structural pressures brought on by the widening wedge between deposit growth and credit growth. A day prior to the 3rd quarter review of monetary policy 2012-13, banks borrowed Rs 1,10,165 crore compared with the average daily borrowing of Rs 98,000 crore in the current month under the Liquidity Adjustment Facility (LAF). Such borrowing figure is despite two successive cuts in Cash Reserve Ratio (CRR) in the recent past and Open Market Operations (OMOs) which together have injected Rs 470 billion into the banking system.

Monetary Policy Action...
Thus in the background of the aforementioned macroeconomic assessment and as tipping point in the balance of risks between growth and inflation on the domestic front, it was been decided by the Reserve Bank of India (RBI) as under:

To reduce the repo rate from 8.00% to 7.75% (a reduction of 25 basis points (bps) with immediate effect); and
Reduce reverse repo rate from 7.00% to 6.75%

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 also is thus adjusted to 8.75%, and so is the bank rate to 8.75%

Moreover, in order to address to the tight liquidity conditions as cited above, it was decided to reduce the CRR by 25 bps from 4.25% to 4.0%, which in turn has an effect of infusing Rs 18,000 crore of primary liquidity in the banking system.

Policy rate tracker

	Increase / (Decrease) in FY12-13	At present
Repo Rate	(75 bps)	7.75%
Reverse Repo Rate	(75 bps)	6.75%
Cash Reserve Ratio	(75 bps)	4.00%
Statutory Liquidity Ratio	(100 bps)	23.00%
Bank Rate	(75 bps)	8.75%

(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. Reducing it would infer, borrowing cost of commercial banks may reduce. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may also ease, whereby home loans and car loans may be offered at a lower rate, thereby providing some relief to respective sectors.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Reducing them will imply that commercial banks would fetch lower interest rates as against what they were receiving so far, 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. Reducing it will now infuse primary liquidity into the banking system as mentioned above.

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:

With headline inflation likely to have peaked and non-food manufactured products inflation declining steadily over the last few months, there is an increasing likelihood of inflation remaining range-bound around current levels going into 2013-14. This provides space, albeit limited, for monetary policy to give greater emphasis to growth risks. The above policy guidance will, however, be conditioned by the evolving growth-inflation dynamic and the management of risks from twin deficits.

What are the expected outcomes from monetary policy action?

The policy actions and the guidance in this Statement given are expected to:

Support growth by encouraging investment;
Continue to anchor medium-term inflation expectations on the basis of a credible commitment to low and stable inflation; and
Improve liquidity conditions to support credit flow.

Projections for domestic economic growth and inflation:

It is noteworthy that central bank had set a GDP forecast for the year 2012-13 in its 1st quarter review of monetary policy at 6.5%, but subsequently it was reduced to 5.8% in the 2nd quarter review of monetary policy. Even now given that industrial activity has remained subdued, there's moderation in consumption, new investment demand is weak and with severe winter in certain parts of the country affecting rabi crops; the baseline projection of GDP growth for 2012-13 is further revised downward to 5.5%.

Likewise for WPI inflation, it is expected to remain range-bound current levels due to persisting food inflation, the pass-through of diesel price adjustments over the next several months and the possibility of adjustment in other administered prices. If international commodity prices, including of crude, move further downwards, they should cushion the phased increase in diesel prices, provided they are not offset by currency movements. A sustained reduction in inflation pressure is, however, contingent upon alleviation of supply constraints and progress on fiscal consolidation. This will also help mitigate the cost-push pressures stemming from the surge in wages. Keeping in view the expected moderation in non-food manufactured products inflation, domestic supply-demand balances and global trends in commodity prices, the baseline WPI inflation projection for March 2013 is revised downwards from 7.5% (as set out in the 2nd quarter review of monetary policy) to 6.8%.

It is noteworthy that during 2000s, inflation has averaged around 5.5%, both in terms of WPI and CPI (down from the earlier trend of 7.5%). So given this record, the central bank has indicated that the conduct of monetary policy will continue to condition and contain perception of inflation in the range of 4.0% - 4.5%; which is in line with the medium-term objective of 3.0% inflation consistent with India's broader integration into the global economy.

What should Debt fund investors do?

The guidance from the monetary policy as enunciated by the RBI has touched the tipping point in balancing growth-inflation dynamics. However the guidance will be conditioned going forward with the evolving growth-inflation dynamics and the management of twin deficit risk. It is noteworthy that at present the economy is exposed to the following risks:

Widening Current Account Deficit (CAD)
Missing the fiscal deficit target (of 5.3%)
Intermediate inflationary pressures
Global economic factors

We have already seen most of the debt market rally happening in the past few weeks on expectation of 25 bps rate cut from the RBI in its stance of addressing to growth risk (as reflected by the slowdown in GDP growth rate). Now for yields to fall any further, aggressive rate cuts are required; which looks dim in the backdrop of macroeconomic assessment done by the central bank and the risk factors. For the debt market, Union budget 2013 would now be an important event as that will guide the markets how fiscal consolidation will happen. It is noteworthy that any spill leading to higher borrowing estimates and deficit may lead to a negative sentiment and bond yields may see an upside shoot of 25bps to 30bps. We expect another 25 bps reduction in policy rates by March 2013, followed by another 50 bps till December 2013 if inflation indeed mellows down and signs of moderation therein appear.

Hence we may not see a swift bond market rally as we witnessed in the recent past, but the conditions still looks lucrative to make decent gains in debt markets. Any intermediate rally will be short lived and hence one should not get carried away towards instruments having high interest rate sensitivity. The key will be to spread your bond portfolio across maturity. If you wish to play the interest rates, then you need to closely monitor the yield movement and take timely step to shift portfolio maturity.

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 month, 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 a little more 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 could 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 7.50% - 9.00% p.a.