Signs of pause in rate hikes appears likely!!

Yet again in its 2nd Quarter Review of Monetary Policy 2011-12 held today (i.e. on October 25, 2011), the Reserve Bank of India increased key policy rates – the repo and reverse repo rates by 25 basis points. The continuation of the calibrated exit stance by increasing key policy rates comes on the back of the concern regarding stubbornly high inflation (though the de-seasonalised quarter-on-quarter headline and core inflation measures, indicate moderation which in turn will bring down the inflation numbers beginning December 2011) and prices of crude oil remaining firm (adding to India’s import bill). Moreover, since the year-on-year (y-o-y) broad money supply (called M3 in economic terms) growth displayed a surge of 16.2% (backed by good deposit growth) and non-food credit growth surged 19.3%, acted as an initiating factor since broad money supply and non-food credit growth outpaced the central bank’s projection of 15.5% and 18.0% respectively for the year.

However, RBI’s anti-inflationary stance has come despite the domestic economic growth showing signs of moderation and slowdown amidst uncertainties in the global arena.

The change in the key policy rates are as under:

Repo rate increased by 25 basis points from 8.25% to 8.50%; and

Reverse Repo rate increased by 25 basis points from 7.25% to 7.50%

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 raised by 25 basis points].

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 13th successive increase since March 2010, where so far the change in the policy rates, CRR and SLR is as under:
 

	Increase / (Decrease) since March 2010	At present
Repo Rate	375 bps	8.50%
Reverse Repo Rate	425 bps	7.50%
Cash Reserve Ratio	100 bps	6.00%
Statutory Liquidity Ratio	(100 bps)	24.00%
Bank Rate	Unchanged	6.00%

(Source: RBI, PersonalFN Research)

 

The Reserve Bank of India (RBI) has also deregulated the savings bank deposit rate with immediate effect. With this deregulation coming into effect banks are free to determine their savings bank deposit interest rate, subject to the following two conditions:

 

• Each bank will have to offer a uniform interest rate on savings bank deposits up to 1 lakh, irrespective of the amount in the account within this limit.
   
• Further, for savings bank deposits over 1 lakh, a bank may provide differential rates of interest, if it so chooses. However, there should not be any discrimination from customer to customer on interest rates for similar amount of deposit.
   

Reasons for RBI’s aggressive stance:

 

• Inflationary pressures
  
  The headline inflation as measured by the Wholesale Price Index (WPI) has been stubbornly high, holding it’s above 9.0% mark for ten consecutive months which is above the comfort zone of RBI (i.e. 6.0% to 7.0%).

(Source: Office of Economic Advisor, PersonalFN Research)

 

Moreover, on an annual basis the food inflation became more expensive by 9.32% and similarly inflation in the fuel and power segment stood at 15.10% in September 2011. Also, with 12 times increase in petrol prices over the last 15 months to correct the under-recoveries of oil marketing companies the chances of inflation ascending in future has increased. In fact accounting for this, RBI had 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 going further.

Hinting on its monetary policy stance going forward, the RBI commented – “notwithstanding current rates of inflation persisting till November, the likelihood of a rate action in the December mid-quarter review is relatively low. Beyond that, if the inflation trajectory conforms to projections, further rate hikes may not be warranted. However, as always, actions will depend on the evolving macroeconomic conditions.”

(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:
 

• On the basis of a credible commitment to low and stable inflation, medium-term inflation expectations will remain anchored.
• The emerging trajectory of inflation, which is expected to begin to decline in December 2011, will be reinforced.
• Contribute to stimulating investment activity.



 

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% - 9.40% 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 not hurt the tightening liquidity situation.

GDP estimate:

Based on the current and evolving macroeconomic situation, the RBI has revised downwards the baseline projection of GDP growth for 2011-12 to 7.6 per cent.

In our opinion the growth rate projected by the RBI now looks achievable as the monetary policy actions undertaken earlier to control 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 in the medium term.

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 watchfulness in taming intolerant levels of WPI inflation (caused mainly due to primary articles, fuel groups and manufactured products), in a scenario where economic growth rate has already dwindled since March 2010 levels.

  Health of India’s economy

(Source: CSO, PersonalFN Research)

 

But ascertaining 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 as on trade, finance and confidence channels.

 

• Slowdown in the U.S. GDP growth along with unemployment rate being still high (at 9.1% in September 2011)
• Debt overhang situation in the Euro zone
• Abrupt rise in long-term interest rates in highly indebted advance economies
• Accentuation of inflationary pressures in EMEs
   

Inflation is likely to peak out in the months of October 2011 and November 2011; post that we may see cooling-off of the inflation numbers due to high base effect in the month of December 2011 where we can expect the RBI in its 3rd Quarter Mid-review of Monetary Policy 2011-12 taking a breather from its anti-inflationary stance. But on the flip side, if inflation does not come below the 9% mark, then we may even see further rate hike action by the RBI in its 3rd Quarter Mid-review of Monetary Policy 2011-12 meeting. So we have to closely watch the inflation numbers for October 2011 and November 2011 and economic growth indicators to judge further action from the RBI.

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 6 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% - 9.40% p.a.

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