RBI's 4th quarter mid-review of Monetary Policy 2011-12   Mar 15, 2012

Interest rate may fall, beginning April 2012. RBI indicates end of rate hikes!

Consequent to a cut in Cash Reserve Ratio (CRR) of 75 basis points on March 9, 2012 to ease the tight liquidity situation in the system (due to advance tax payment obligation scheduled on March 15, 2012), the Reserve Bank of India (RBI) in its 4th quarter mid-review of monetary policy 2011-12 maintained a status quo in its policy action (i.e. on repo rate, reverse repo rate and CRR).

Thus now, the policy rates have been kept unchanged as under:

  • Repo rate at 8.50%; and

  • Reverse Repo rate at 7.50%

Thereby, maintaining the Liquidity Adjustment Facility (LAF) corridor between repo and reverse repo rate at 100 basis points, and Marginal Standing Facility (MSF) rate and the bank rate at 9.50%.

Moreover, since the CRR cut of 75 bps announced on March 9, 2012 already injected liquidity worth Rs 48,000 crore, the central bank kept the CRR too unchanged at its last reduced level of 4.75%. It is noteworthy that the aggressive reduction in CRR was fuelled by the fact that nearly Rs 1.50 lakh crore CDs would mature by March-end, and liquidity would further tighten ahead of advance tax outflow of nearly Rs 60,000 crore on March 15, 2012.

[PersonalFN expected policy rates (both repo as well as the reverse repo) to be unchanged, along with status quo on CRR, due to aggressive reduction on March 9, 2012].

Similarly the Statutory Liquidity Ratio (SLR) has 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%).

Hence if we assess, after bringing in 13 successive increases since March 2010 to tame the inflation bug at the cost of economic growth, the central bank is now delicately trying to poise balance between domestic economic growth and inflation; given a highly uncertain economic environment still prevailing. It is noteworthy that this is the third successive time the central bank has turned the pause button for policy rates, and has addressed to the liquidity situation as well by reducing CRR by 125 basis points in the last couple of months.

Policy rate tracker

  Increase / (Decrease) since March 2010 At present
Repo Rate 375 bps 8.50%
Reverse Repo Rate 425 bps 7.50%
Cash Reserve Ratio (125 bps) 4.75%
Statutory Liquidity Ratio (100 bps) 24.00%
Bank Rate 350 bps
(w.e.f. Feb 13, 2012 )
9.50%

(Source: RBI website, PersonalFN Research)


Reasons for this monetary policy action:

  • Modest improvement in global macro-economic scenario

    Speaking first about the U.S., their macro-economic data reveals a modest improvement in economic growth rate. In the last four quarters of year 2011 there has been an ascending trend in the quarter-on-quarter (Q-o-Q) growth rate (in Q4 of 2011 the GDP, they reported a growth rate of 3.0%), and the unemployment rate too has dwindled (8.3% in January 2012). However, the U.S. Fed expects that economic conditions warrant exceptionally low levels for the federal funds rate at least through late 2014.

    Similarly as far as the Euro zone is concerned, the immediate financial pressures in the euro area have been eased to some extent by the European Central Bank (ECB) injecting liquidity of more than € 1 trillion through the two long-term refinancing operations. But worry lines are still evident as their Q4 2011 growth has turned negative (i.e. -0.3%), and thus as a result of the worries in Euro zone, Emerging and Developing Economies (EDEs) too are showing signs of slowdown. In fact growth for 2012 and 2013 is expected to lower than earlier anticipated.

    Also since inflation in both advanced economies and EDEs is moderating, it encouraged the RBI to maintain a status quo on policy rates.

  • Headwinds in the domestic economy

    WPI inflation
    The drop in Wholesale Price Index (WPI) inflation for January 2012 (to 6.55%) followed by marginal increase of 40 bps in February 2012 encouraged the central bank to maintain a status quo in policy rates, as it signaled moderation in WPI inflation stemmed by mainly by:

    • Primary food articles; (Primary food inflation articles turned modest 0.8% in December 2011, turned negative i.e. -0.5% in January 2012, before rising to 6.1% in February 2012)

    • Fuel; (Fuel group inflation moderated to 12.8% in February 2011 from 15.0% despite international crude oil prices galloping since December 2011)

    • Non-food manufactured products (Non-food manufactured products moderated to 5.8% in February, as against 7.9% in December 2012)

The inflation bug crawling down!


(Source: Office of Economic Advisor, PersonalFN Research)

But since Consumer Price Index (CPI) inflation (as measured by the new series, base year 2010) was 7.7%, suggesting that upward price pressures still remain at the retail level, the RBI has refrained from reducing policy rates in this review meeting.

We think that it would be interesting to see how the WPI inflation chart takes shape in the ensuing months. This is because primarily the drop in WPI inflation is a "statistical effect"- high base effect, which may fade in the ensuing months.

Moreover, the jump in primary food articles inflation (to 6.1% in February 2012) is worrisome in our view. Also if crude oil prices continue galloping further, oil marketing companies too would take a cohesive decision with the Government to increase fuel prices (to correct their under-recoveries) which in turn may prove to have a detrimental impact on overall inflation. At present, while fuel inflation for February 2012 has mellowed (to 12.8%), Brent crude oil prices are hovering above the U.S. $ 120 per barrel, due to worry of supply contraction occurring from Iran and North Sea (marginal sea of Atlantic Ocean). The present uptrend in oil prices has also occurred due to likely fall in output of crude oil in March 2012 from the North Sea due to maintenance work and natural aging of oilfields there. Moreover, since the Indian rupee lingering is near Rs 50 per U.S. dollar mark, the risk of "imported inflation" creeping in still persists.

Slippage in the fiscal deficit too has been adding to inflationary pressures, and thus addressing to the issue of fiscal consolidation in Union Budget 2012 would be a vital factor in shaping the inflation curve.


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

GDP growth rate
The deceleration in the economic growth rate consecutively in the last five quarters of the current fiscal year also encouraged the RBI to be accommodative. India’s economic growth for the third quarter of the fiscal year 2011-12 has fallen to a 2-year low of 6.1% from 6.9% clocked in the previous quarter of the fiscal year, thus reflecting a slowdown in industrial activity. It is noteworthy that although the Index of Industrial Production (IIP) for January 2012 is 6.8% (data released in February 2012,) the trend in the last one year has been descending, with ‘see-saw’ movements.

But given the volatility in IIP, the RBI has also used several other indicators to assess the overall industrial activity. With manufacturing PMI (Purchasing Managers’ Index) suggesting an expansionary mode along with Q3FY12 corporate sales being robust, but margins moderating; the central bank has adopted policy stance as cited above.

Liquidity conditions
While liquidity in the system primarily remained in the deficit mode, but since steps such as reduction in CRR by 125 bps (50 bps in 3rd quarter review of monetary policy 2011-12 and 75 bps on March 9, 2011) and Open Market Operations (OMOs) – aggregating Rs 1,24,700 crore, helped to inject primary liquidity of about Rs 80,000 crore; the central bank’s monetary policy action was guided as cited above.

RBI’s GDP estimate:

Based on the current and evolving macroeconomic situation, the RBI’s growth projection for the Indian economy has been set at 7.0%, which is almost in line with the Central Statistics Office’s estimate of 6.9%.

We believe that the growth rate projected by the RBI looks achievable as the monetary policy actions undertaken earlier to control inflation may have a detrimental impact on India’s GDP growth rate. Moreover with global risk prevailing, a growth rate below 8.0% looks more probable.

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 means, there are unlikely chances of an increase in borrowing cost of commercial banks. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may remain unchanged, as the commercial banks in the country too may maintain a status quo at least until the liquidity in the system stabilises.

Similarly, the interest rates on fixed deposits are expected to remain firm until further monetary policy action. 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. Keeping them unchanged will result in commercial banks continuing to enjoy the same interest rates as earlier, for parking their surplus funds with RBI.

The Cash Reserve Ratio is the amount of amount of liquid cash which the banks are supposed to maintain with RBI. Keeping it unchanged at the last reduced level of 4.75% may provide comfort to the liquidity situation which has been tight since November 2011.

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 liquidity situation.

Guidance from monetary policy and path for interest rates

By keeping the policy rates unchanged, along with CRR to it last reduced level of 4.75% (after an intermediate CRR cut announced on March 9, 2012) the central bank has addressed to the persistent structural liquidity deficit, which was beyond their comfort level. The recent growth-inflation dynamics have prompted the RBI to indicate that no further tightening is required and that future actions will be towards lowering policy rates. However, notwithstanding the deceleration in growth, inflation risks remain, which will influence both the timing and magnitude of future rate actions.

What should Debt fund investors do?

We believe that the current situation is attractive to take exposure to debt mutual fund instruments (especially a mix of short-term and long-term debt funds) as the central bank has distinctly indicated this to be the peak of the interest rate cycle, but subject to growth and inflation risk as cited above. Thus this would be the peak, after which interest rates are expected to go down from the next fiscal year (i.e. 2012-13).

Hence now, you can 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 also be considered, if one has a longer 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 the longer maturity instruments.

With liquidity in the system being tight, yield on the short term instruments is expected to remain high thus making short-term papers 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 month 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 upto 1 year would continue to 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; at present 1 year FDs are offering interest in the range of 7.25% - 9.25% p.a.