RBI trying to hold the inflation monster by its neck!!

The Reserve Bank of India (RBI) in its 1^st Quarter Review of Monetary Policy 2011-12 held today (i.e. July 26, 2011) continued to maintain its anti-inflationary stance, but this time again turned hawkish as it increased policy rates – both repo rate as well as reverse repo rate by 50 basis points. The elevated commodity prices along with robust demand in the Emerging Market Economies (EMEs) (which includes India as well) also prompted RBI to take such a measure. Moreover, since the year-on-year (y-o-y) broad money supply (called M3 in economic terms) growth displayed a surge of 17.1% (backed by good deposit growth of 18.4%), it acted as an initiating factor since broad money supply outpaced the central bank’s indicative trajectory of 15.5% (indicative trajectory revised downwards from 16.0% as set out in May 3, 2011 policy statement).

 

Thus now the policy rates are as under:

 

Repo rate increased by 50 basis points from 7.50% to 8.00%; and Reverse Repo rate increased by 50 basis points from 6.50% to 7.00%

 

Thereby maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis points.

 

However assessing the fact that liquidity has transited from a surplus to a deficit mode, the Cash Reserve Ratio (CRR) is kept unchanged at 6.00%.

 

[PersonalFN expected policy rates (both repo as well as the reverse repo) to increase by 25 basis points, in a move to tame inflation, without hurting economic growth].

 

Statutory Liquidity Ratio (SLR) has also been kept unchanged at its last reduced level of 24% (In the third quarter mid-review of monetary policy 2010-11 on December 16, 2010, SLR was reduced from 25% to 24%).

 

Bank rate too has been left unchanged at 6.00%.

 

Hence if we assess, this has been the 11^th successive increase since March 2010, where so far the hike in the policy rates, CRR and SLR is as under:

 

	Increase / (Decrease) since March 2010	At present
Repo Rate	325 bps	8.00%
Reverse Repo Rate	375 bps	7.00%
Cash Reserve Ratio	100 bps	6.00%
Statutory Liquidity Ratio	(100 bps)	24.00%
Bank Rate	Unchanged	6.00%

(Source: RBI, PersonalFN Research)

Reason for such an aggressive stance:

• Inflationary pressures
  
  Persistent inflationary pressures instigated RBI to adopt hawkish stance (by increasing policy rates) as WPI inflation continues to remain above the comfort level of 8.00%.
   

  
  (Source: Office of Economic Advisor, PersonalFN Research)

  
  Moreover, the central bank is of the opinion that WPI inflation would still continue to trend-up due to the following reasons:
   
  • Increase in administered fuel prices brought in June 2011(which may further add around 70 bps to WPI inflation)
  • Global crude oil prices remaining sticky (with Brent crude oil over U.S. $115 per barrel)
  • Significant increase in Minimum Support Price (MSP) of some agriculture commodities, particularly rice and pulses (which may put upward pressures on food inflation despite a good harvest)
  • Elevated prices of non-food manufacturing items inflicted by demand side pressures
  
  
  
   
  But going forward, the RBI also believes that WPI inflation would take its course depending on the following factors:
   
  • Overall performance of the south-west monsoon (Even if there is no major deficiency at the aggregate level, an appropriate spatial and temporal distribution of rainfall during the whole season is crucial.)
  • Prices of global crude oil (Since they are still uncertain and are still hovering over the U.S. $115 per barrel mark, and aren’t really displaying a downward trend, despite reduction in demand from advanced economies)
  • Suppressed element of inflation in the economy (For example: Despite the recent increase in administered fuel prices, under-recoveries on account of subsidised fuel are estimated at over 1,00,000 crore (1.0 per cent of GDP) of which a major portion may have to be borne by the Government. Regardless of how this issue is handled, there will be implications for inflation. If the Government raises administered prices, the inflation implications are straightforward. If the Government absorbs this in the fiscal accounts, the resultant expansionary impact will add to inflation pressures.)
  
  
  
   
  Thus taking a view of the aforementioned situation, the RBI has placed its baseline projection for WPI inflation for March 2012 at 6.00% with an upward bias of upto 7.0%. Inflation is expected to remain at an elevated level for a few more months (of the fiscal year), before moderating towards the later part of the year.
  
  (PersonalFN’s forecast for inflation range is 7.00% - 7.50% by March 2012)
   
• No sharp or broad-based slowdown
  
  While there are signs of growth moderation in some interest sensitive sectors, there is no evidence of a sharp or a broad-based slowdown as yet. Several indicators such as exports and imports, indirect tax collections, corporate sales & earnings and demand for bank credit suggest that demand is only moderating - and that too gradually; which in turn led to RBI take such a move.
  
  Thus against the backdrop of current and evolving growth and inflationary scenario, the RBI believes that there is a need to persevere its anti-inflationary stance of monetary policy.


 

Expected outcome from the policy stance:

 

The central bank’s stance of increasing policy rates by 50 basis points is expected to:

 

• Reinforce the cumulative impact of past actions on demand;
• Maintain the credibility of the commitment of monetary policy to controlling inflation, thereby keeping medium-term inflation expectations anchored; and
• Reinforce the point that in the absence of complementary policy responses on both demand and supply sides, stronger monetary policy actions are required


 

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. Increasing repo rate means, there will be increase in the borrowing cost of commercial banks. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may go up, as the commercial banks in the country may hike lending rates further.

 

Similarly, the interest rates on fixed deposits are also expected to move up slightly from the current levels. At present 1 yr FDs (Fixed Deposits) are offering interest in the range of 7.25% - 9.25% p.a.

 

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Increasing them will result in commercial banks continuing to enjoy higher interest rates for parking their surplus funds with RBI.

 

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 them unchanged would unhurt the tightening liquidity situation due to advance tax payment obligation.

 

GDP estimate:

 

Based on the assumption of a normal monsoon and crude oil prices averaging at US $ 110 per barrel over fiscal year 2011-12, the baseline projection of real GDP growth for fiscal year 2011-12 is kept unchanged at around 8.0% (as stated in Annual Monetary Policy Statement 2011-12). But the RBI has also added a probability range of 7.45% to 8.50% while estimating the country’s economic growth rate.

 

But in our opinion the growth rate projected by the RBI looks quite optimistic as the central banks vigil of controlling inflation may hamper India’s GDP growth rate. Moreover with global risk prevailing (as mentioned below) a growth rate below 8.0% looks more probable. So even though the RBI may have broadly taken step in the right direction to actively control the spiraling high inflation, it has done so at the cost of sacrificing economic growth.

 

Economic outlook paving the path for interest rates

 

The central bank’s stance of increasing the policy rates by 50 basis points reveals the central bank’s vigilance in taming intolerant levels of WPI inflation (caused mainly due to crude oil prices and other non-food items), in the scenario of moderation of economic growth. Moreover the global economy is poised with worrisome factors such as:
 

• Slowdown in the U.S. GDP growth (1.9 percent in the first quarter of 2011) along with unemployment rate being still high (at 9.2% in June 2011)
• Debt overhang situation in Euro zone
• Abrupt rise in long-term interest rates in highly indebted advance economies
• Accentuation of inflationary pressures in EMEs



 

Hence given all the aforementioned facets, if the global economic recovery slackens significantly, then we may witness a negative impact on Indian economy too on trade, finance and confidence channels.

 

Moreover, if WPI inflation continues to display its northward journey the RBI would not refrain from increasing policy rates further, where we can expect another 25 basis points increase to take place in the next 3 months.

 

What should Debt fund investors do?

 

Thus taking into account the fact that interest rates are at elevated levels and almost nearing their peak, we recommend that you now gradually take exposure to pure income and short-term Government securities funds, since longer tenor papers will become attractive. Longer duration funds (preferably through dynamic bond / flexi-debt funds) can be considered, if one has a longer investment horizon (of say 2 to 3 years).

 

Moreover since the additional 25 basis points rate hike elevates the chances of liquidity getting tight, yield on the short term instruments are expected to move up slightly (say by 25 bps to 50 bps) thus making short term papers more attractive, investors with a short-term time horizon (of less than 3 months) would be better-off investing in liquid funds for the next 1 - 1½ months or liquid plus funds for next 3 to 6 months horizon. However, investors with a medium term investment horizon (of over 6 months), may allocate their investments to floating rate funds.

 

Short term income funds should be held strictly with a 1 year time horizon. Fixed Maturity Plans (FMPs) of 3 months to 1 year will yield appealing returns and can also be considered as an option to bank FDs only if you are willing to hold it till maturity, but you may not have a very attractive post tax benefit as indexation benefit will not be available on FMPs maturing within 8 months.

 

You should invest in longer duration funds, if the time horizon is of over 2 to 3 years. But you may witness some volatility in the near term as there is always an interest rate risk involved in the longer maturity instruments.

 

You can consider investing your money in Fixed Deposits (FDs). At present 1 yr FDs are offering interest in the range of 7.25% - 9.25% p.a.

Add Comments

Comments
fcfpmng@rcflood.org Aug 19, 2011 There is a criitcal shortage of informative articles like this.

 1