RBI’s Anti-Inflationary Campaign Continues

The Reserve Bank of India (RBI) in its 2nd Quarter Mid-review of Monetary Policy 2011-12 held today (i.e. September 16, 2011) continued to maintain its anti-inflationary stance, as it increased policy rates – both repo rate as well as reverse repo rate by 25 basis points. The elevated commodity prices backed by a robust demand in the Emerging Market Economies (EMEs) (which includes India as well) 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 16.7% (backed by good deposit growth), it acted as an initiating factor since broad money supply outpaced the central bank’s projection of 15.5% for the year.

However, RBI’s anti-inflationary stance has come in despite dissemination of downbeat global economic factors steered by the debt-overhang situation in the Euro zone (due to failure of Greece and Italy to put its public finances in place) and fragile economic recovery in the U.S. (Q-o-Q GDP growth rate at mere 1.00% in last quarter i.e. April 2011 to June 2011).

Thus now the policy rates are as under:

Repo rate increased by 25 basis points from 8.00% to 8.25%; and

Reverse Repo rate increased by 25 basis points from 7.00% to 7.25%

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 remained in the deficit mode, consistent with the stance of the monetary policy, the Cash Reserve Ratio (CRR) is kept unchanged at 6.00%.

[PersonalFN expected policy rates (both repo as well as the reverse repo) to be kept unchanged as downbeat global economic headwinds swirl around, as this would have left economic growth rate unhurt].

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 12th successive increase since March 2010, where so far the hike in the policy rates, CRR and SLR is as under:
 

Policy rate tracker

	Increase / (Decrease) since March 2010	At present
Repo Rate	350 bps	8.25%
Reverse Repo Rate	400 bps	7.25%
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 a stance:

 

• Inflationary pressures
   

Persistent inflationary pressures instigated RBI to maintain its anti-inflationary stance (by increasing policy rates) as WPI inflation continued to sail over the 9.00% mark for nine consecutive months, thereby being above RBI’s comfort level of 8.00%.

 

(Source: Office of Economic Advisor, PersonalFN Research)

 

Inflation in respect of primary articles and fuel groups edged up in August 2011. Year-on-year non-food manufactured products inflation has risen from 7.5% in July to 7.7% in August 2011 suggesting yet persistent demand pressures. Moreover, now with 12 times increase in petrol prices in the last 15 months to correct the under-recoveries of oil marketing companies, elevates the chances of inflation ascending. In fact accounting for this, RBI has said that "it will have a direct impact of 7 basis points (bps) to WPI inflation, in addition to indirect impact with a lag." Also the central bank is of the view that the recent depreciation in the Indian Rupee may also have adverse implications for inflation.

Hence given that, the central bank would continue with its anti-inflationary stance as the 2nd quarter mid-review of monetary policy 2011-12 states - "It is imperative to persist with the current anti-inflationary stance. Going forward, the stance will be influenced by signs of downward movement in the inflation trajectory, to which the moderation in demand is expected to contribute, and the implications of global developments."

(PersonalFN ’s forecast for inflation range is 7.00% - 7.50% by March 2012)

Expected outcome from the policy stance:

The central bank’s stance of increasing policy rates by 25 basis points is expected to:

 

• Reinforce the impact of past policy actions to contain inflation and anchor inflationary expectations
   

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 hurt the tightening liquidity situation due to advance tax payment obligation.

GDP estimate:

Based on the assumption of a normal monsoon, the baseline projection of real GDP growth for fiscal year 2011-12 is kept unchanged at around 8.0%; but added a probability range of 7.45% to 8.50% while estimating the country’s economic growth rate (as stated in Annual Monetary Policy Statement 2011-12). However being wary of the developments in the global economy, which may dampen domestic demand the central bank explicates that the risk to growth projections are on the downside.

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 25 basis points reveals the central bank’s vigilance in taming intolerant levels of WPI inflation (caused mainly due to primary articles and fuel groups), in a scenario where economic growth rate has already dwindled since March 2010.

  Health of India’s economy

(Source: CSO, PersonalFN Research)

 

But ascertain that the global economy is poised with worrisome factors such as the ones mentioned below, the slackening in global economic recovery may occur, which may have a negative impact on India as well - on trade, finance and confidence channels.

 

• Slowdown in the U.S. GDP growth along with unemployment rate being still high (at 9.1% in August 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



 

Moreover if WPI inflation indeed continues to display its northward journey due to a pass-through effect of increase in petrol prices, then it makes a case stronger for further rate hikes; where we can expect another 25 basis points increase to take place in its 2nd quarter review of monetary policy 2011-12 (scheduled on October 25, 2011).

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. Hence 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 7 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 associated with 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.

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Comments
767703100@qq.com Sep 28, 2011 That addresses several of my conecnrs actually.
curtis@hessrohmercpa.com Sep 28, 2011 Stellar work there everyone. I'll keep on reading.

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