RBI 3rd quarter mid-review of monetary policy 2011-12
Dec 16, 2011

Author: PersonalFN Content & Research Team

Invest in debt MFs wisely, as RBI takes a pause in policy action

Worsening global economic outlook, since its last quarter review of monetary policy 2011-12 (held on October 25, 2011) has finally guided the Reserve Bank of India (RBI) to press the pause button in its monetary policy action, thus keeping policy rates 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 at 9.50%.

Moreover, after yesterday’s intervention to curb the volatility in the Indian rupee by banning shorts in forward contract market, the central bank maintained a dovish stance on the Cash Reserve Ratio (CRR) as well (keeping it unchanged at 6.00%), in a scenario where markets did expect (before currency market intervention) a CRR cut due to the tight liquidity situation.

[PersonalFN expected policy rates (both repo as well as the reverse repo) to be unchanged but a reduction in CRR before currency market intervention].

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, after bringing in 13 successive increases since March 2010 to tame the inflation bug at the cost of economic growth, the central bank has turned accommodative given the gloomy scenario in the developed economies, and its impact on Emerging Market Economies (EMEs) as well.

	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 website, PersonalFN Research)

Reasons for maintain a status quo:

Gloomy global economy

Since the recent European Union (EU) Summit too did not assuage negative market sentiments, thus leading to financial turbulence to persist across both – developed and emerging market economies, the central bank preferred to maintain a status quo. In the EU summit while the European leaders did agree on a new fiscal compact, involving stronger coordination of economic policies to strengthen fiscal discipline, the medium and long-term sustainability of the Euro zone to resolve the short-term funding pressures was questioned by markets. Q3 growth (of 0.8%) in the Euro zone was anemic and 2012 growth is now expected to be weaker than earlier projected. And interestingly reflecting these projections, the European Commercial Bank (ECB) has cut its policy rates twice in the last two months, and has also implemented some non-standard measures. Speaking about the U.S., while they have recorded a better Q3 economic growth (of 2.0%), as compared to the immediate last quarter, the overall trend still appears substantially below trend. Growth in the EMEs is also moderating steered by the economic turmoil prevailing in the developed economies and impact of monetary policy to contain inflation.
Headwinds in the domestic economy

WPI inflation The drop in November 2011 WPI inflation (data released on December 14, 2011) to a 12 month low of 9.11%, mainly due to softening in food inflation (4.35% for the week ended December 3, 2011) also encouraged the RBI to maintain a status quo in policy rates, as it signaled moderation in WPI inflation.

(Source: Office of Economic Advisor, Personal FN Research)

But interestingly if we assess the stubbornness in WPI inflation is still evident as it continues to be over the 9.00% mark for consecutive 12 months, and is still above the 6.00% - 7.00% comfort range of the central bank. Moreover, elevated borrowing cost and surge in input cost has kept manufacturing inflation, still high at 7.9% in November 2011 (up 2 basis points from the October 2011 level).

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

GDP growth rate
The deceleration in the economic growth rate consecutively since Q2FY11 also encouraged the RBI to be accommodative. India’s economic growth for the second quarter of the fiscal year 2011-12 has fallen to a 2-year low of 6.9% from 7.7% clocked in the previous quarter of the fiscal year, due to sharp moderation in industrial growth to -5.1% after showing a dismal growth of 2.0% as reported in the previous month.

Fiscal deficit
The central Government’s key deficit indicator worsening (during the April to October 2011 period) primarily on account of a decline in revenue receipts and increase in expenditure - particularly subsidies, also encouraged the central bank to be accommodative. The fiscal deficit at 74.4% of the budgeted estimate in the first seven months of 2011-12 was significantly higher than 42.6% in the corresponding period last year.

Liquidity conditions
Being consistent with monetary policy action taken so far, liquidity condition has remained in deficit during this fiscal year, which in turn led to the central bank maintaining policy rates unchanged

RBI’s GDP estimate:

Based on the current and evolving macroeconomic situation, the RBI’s growth projection for the Indian economy as set out in the 2nd quarter review of monetary policy 2011-12 (held on October 25, 2011) have increased substantially, where the baseline projection of GDP growth for 2011-12 is at 7.6%.

We believe that the growth rate projected by the RBI looks achievable as the monetary policy actions undertaken earlier to control inflation may hamper 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.

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% - 9.40% 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 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 tight liquidity situation.

Guidance from monetary policy and path for interest rates

While inflation remains on its projected trajectory, downside risks to growth have clearly increased. Also in view of moderating growth momentum and higher downside risks to growth, monetary policy actions are likely to reverse the cycle, responding to the risks to growth.

However, it must be emphasised that inflation risks remain high and inflation could quickly recur as a result of both supply and demand forces. Also, the rupee remains under stress. The timing and magnitude of further actions will depend on a continuing assessment of how these factors shape up in the months ahead.

What should Debt fund investors do?

We believe that the current situation is attractive to take exposure to debt mutual fund instruments as interest rates are likely to consolidate at these higher levels before they start going down.

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 be also 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 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 4 months. 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% - 9.40% p.a.