RBI's Mid-Quarter Review of Monetary Policy - 2011-12
Jun 16, 2011

Author: PersonalFN Content & Research Team

RBI back to its baby steps to tame inflation

The Reserve Bank of India (RBI) in its Mid-Quarter Monetary Policy Review held today (i.e. June 16, 2011) continued to maintain its anti-inflationary stance and thus once again adopted its calibrated exit path and increased policy rates – both repo rate as well as reverse repo rate by 25 basis points. The year-on-year (y-o-y) increase in broad money supply (called M3 in economic terms) from 16.0% in March 2011 to 17.3% in early June 2011 also encouraged the central bank to increase its policy rates.

Thus now the policy rates are as under:

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

Reverse Repo rate increased by 25 basis points from 6.25% to 6.50%

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

However assessing the fact that liquidity is expected to tighten due to advance tax payment obligation, 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 10^th successive increase since March 2010, where so far the hike in the repo rate and the reverse repo rate has been 275 basis and 325 basis points respectively.

Reason for such a policy stance:

Inflationary pressures

Persistent inflationary pressures instigated RBI to adopt its calibrated exit path (by increasing policy rates) as WPI inflation continues to remain above the comfort level of 8.00% (earlier the comfort level was 7.00%) and once again trending up led by impact of elevated crude oil prices.

(Source: Office of Economic Advisor, PersonalFN)

Moreover, the central bank is of the opinion that WPI inflation numbers understate the pressures because fuel prices have yet to reflect global crude oil prices.

At present Brent crude oil prices have softened after displaying a northward journey since the release of the QEII money. Last month witnessed the mellowing of Brent crude oil prices by good 7.9% led by the slowdown in the U.S. economy, which in turn led to demand for oil in U.S. narrowing down.

In India, the steep hike in petrol prices (by Rs 5) effected by the Government on May 15, 2011 is also likely to put upward pressure on inflation going forward. Moreover with the Government contemplating to increase the prices of diesel and cooking gas the chances of WPI inflation soaring further elevates.

It is noteworthy that diesel is a widely used transport fuel; and hence an absurd hike in the same may make fruits, vegetables and other food items too expensive as transport cost mounts. Moreover, if transporters agitate to such a move by going on a nation-wide stir it would cripple supply across the country, thus putting upward pressure on food prices.

However, if the south west monsoons are normal (which is expected) the moderation in food prices would occur; but the detrimental impact of increase in transport fuel cannot be ruled out. Moreover, with the demand side pressure persisting (which has induced generalisation of commodity prices in the recent months) the likely chances of an upward bias in WPI inflation are still strong.

According to the central bank, the baseline projection for WPI inflation for March 2012 is placed at 6.00% with an upward bias. Inflation is expected to remain at an elevated level in the first half of the fiscal year due to expected pass-through of increase in international petroleum product prices to domestic prices and continued pass-through of high input prices into manufactured products.

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

Thus against the backdrop of current and evolving growth and inflationary scenario, the RBI would continue with its anti-inflationary stance of monetary policy.

Expected outcome from the policy stance:

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

Contain inflation and anchor inflationary expectations by reining demand side pressure; and
Mitigate the risk to growth from potentially adverse global developments

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.

What should Debt fund investors do?

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 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 (1.8 percent in the first quarter of 2011)
Probability of withdrawal of QEII money by end of June 2011
Debt crisis in the Euro zone region
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 50 - 75 basis points increase to take place in the next 6 months.

Thus taking into account the fact that interest rates are at elevated levels and are 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).

While this stiff rate hike will further tighten liquidity from the system and also boost yield on the short term instruments by 25 bps to 50 bps thus making short term papers more attractive. So if you have a short-term time horizon (of less than 3 months) you would be better-off investing in liquid funds for the next 1 - 1½ months or liquid plus funds with a 3 to 6 months horizon. However, if you have a medium term investment horizon (of over 6 months), you may allocate your 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 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 less than 1 year FMPs.

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.