Despite a reduction of 125 basis points in Cash Reserve Ratio (CRR) effected by the Reserve Bank of India (RBI) (in its 3rd quarter review of monetary 2011-12 and intermediately on March 10, 2012) and Open Market Operations (OMOs) aggregating around Rs 1.3 trillion between November 2011 and March 2012, liquidity remained rather tight in the system. In fact throughout the financial year 2011-12 liquidity remained in a deficit mode. Money supply growth which was 17% at the beginning of the financial year 2011-12 (reflecting strong growth in time deposits), later moderated during the course of the year to about 13% by end-March 2012, thereby settling lower than RBI’s indicative trajectory of 15.5%. It mirrored both - tightness in primary liquidity and lower credit demand during most part of the year.

The tight liquidity situation along with a high interest rate regime persisting (due anti-inflationary stance of RBI) in the last financial year also led to detrimental impact on domestic economic growth (along with global headwinds in play). India’s GDP growth depicted a descending trend, industrial activity slowed down and manufacturing Purchasing Manager’s Index (PMI) moderated to 54.7 in March 2012 (from 56.6 in February 2012). Likewise the composite PMI (consisting of both manufacturing and services) also moderated to 53.6 in March 2012 from 57.8 in February 2012. This in turn was also reflected in corporate earnings as profit after tax (PAT) took a downward trajectory. This pattern indicated a steady decline in the pricing power, as producers found it increasingly difficult to pass on rising input costs to their customers.

On the fiscal deficit front, while the Union Budget 2012-13 did initiated a return on fiscal consolidation path, the deviation in revised estimates from the budget estimates for the Central Government finances for the year 2011-12 was disturbing. Likewise, widening Current Account Deficit to 4.0% of GDP (from 3.3% of GDP in April 2010 to December 2010) made imbalance in Balance of Payment (BoP) evident due to a higher trade deficit.

But now as signs of moderation in headline Wholesale Price Index (WPI) inflation are evident (thereby making it consistent with RBIs with indicative projection of 7.0%), RBI has initiated a policy rate cut (after raising policy rates by 375 bps during March 2010 to October 2011 to contain inflation and anchor inflation expectation), thereby also showing concerns towards economic growth dynamics.
 

WPI Inflation cools down further!

(Source: Office of the Economic Advisor, PersonalFN Research)
Monetary Policy action…

It has been decided to:
 

• Reduce the Repo rate by 50 bps from 8.50% to 8.00% with immediate effect; and
   
• Reduce the Reverse Repo rate by 50 bps from 7.50% to 7.00% with immediate effect
   

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

Moreover, in order to provide greater liquidity cushion, it has been decided to raise the borrowing limit of Scheduled Commercial Banks (SCBs) under the Marginal Standing Facility (MSF) from 1.0% to 2.0% of their net demand and time liabilities (NDTL) outstanding at the end of second preceding fortnight with immediate effect. Thus MSF rate determined with a spread of 100 basis points above the repo rate, stands adjusted to 9.0% (from 9.5%) with immediate effect. Likewise the bank rate has also been adjusted to 9.0% (from 9.5%) with immediate effect.

The CRR however, of SCBs were retained at their last reduced level of 4.75%, as the increase in borrowing limit for SCBs (as mentioned) addressed to the liquidity issue.

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%).
 

Policy rate tracker

	Increase / (Decrease) in FY12-13	At present
Repo Rate	(50 bps)	8.00%
Reverse Repo Rate	(50 bps)	7.00%
Cash Reserve Ratio	Unchanged	4.75%
Statutory Liquidity Ratio	Unchanged	24.00%
Bank Rate	(50 bps)	9.00%

(Source: RBI website, PersonalFN Research)

 

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. Reducing it means, borrowing cost of commercial banks will reduce. Hence as a reaction to such a move, cost of borrowing for individuals and corporates may also come down, as the commercial banks in the country would lend at cheaper rates, and this in turn may fuel economic activity in the country.

Similarly, the interest rates on fixed deposits are expected to fall slightly. 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. A reduction reverse repo will result in commercial banks fetching lesser interest rate (as compared to 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.

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.

Expected outcome from the policy stance:

The policy actions taken by the central bank are expected to:
 

• Stabilise growth around its post-crisis trend;
• Contain risk of inflation and inflation expectations re-surging; and
• Enhance liquidity cushion available to the system
   

Guidance from monetary policy and path for interest rates:

The reduction in the repo rate is based on an assessment of growth having slowed below its post-crisis trend rate which, in turn, is contributing to a moderation in core inflation. But having said that, the upside risk to WPI inflation persists and these considerations are limiting the space for further reduction in policy rates. Moreover, persistent demand pressures emerging from inadequate steps to contain subsidies as indicated in the recent Union Budget would further reduce whatever space there is.

Fortunately, liquidity conditions are moving towards the comfort zone of the central bank (as reflected by decline in bank’s borrowing from LAF window and the behaviour of money market rates), and now the increase in MSF limit is further expected to add some cushion to liquidity. But having said that, if the situation changes, appropriate steps would be taken by RBI with the objective of restoring comfort zone conditions.

RBI’s estimates:

GDP growth rate
At present the advance estimate of 6.9% on GDP growth rate for financial year 2011-12 by the Central Statistics Office (CSO) is close to the Reserve Bank’s baseline projection of 7.0%. Going forward into financial year 2012-13; assuming that we have a normal monsoon, industry likely to perform better than last year (leading to turnaround in IIP growth), and global outlook to look slightly better than expected earlier, the GDP growth rate for 2012-13 is projected at 7.3%.

We believe that the growth rate projected by the RBI looks achievable as the monetary policy action taken by the RBI is likely to fuel industrial activity and thus broader economic growth. Moreover, going forward if policy rates are reduced further (evaluating the macro-economic scenario), it may provide an impetus to interest rate sensitive sectors, and thus the consumption steam gathered therefrom can make the GDP growth rate achievable (and even exceed).

Inflation
WPI inflation in 2011-12 has evolved broadly along the trajectory projected by RBI, and even March 2012 WPI inflation at 6.9% was close to RBI’s indicative projection of 7.0%. We too forecasted WPI inflation to fall in the range of 7.00% - 7.50% by March 2012 (due to upside risk in Brent crude oil prices).

Going forward, the inflation scenario remains challenging. Food inflation, after a seasonal decline, has risen again. Inflation in respect of protein-based items remains in double digits. Crude oil prices are expected to remain high and the pass-through of past price increases in the international market to domestic petroleum product prices remains significantly incomplete. There also remains an element of suppressed inflation in respect of coal and electricity. However, non-food manufactured products inflation is expected to remain contained reflecting the lagged effect of past monetary policy tightening on aggregate demand. Corporate performance numbers also indicate that the pricing power has reduced. Consequently, the risk of adjustments in administered prices translating into generalised inflationary pressures remains limited, though there is no room for complacency.

Hence keeping in view of the domestic-supply balance, the global trends in commodity prices and the likely demand scenario, the baseline projection for WPI inflation for March 2013 is placed at 6.5%.

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. We expect WPI inflation to be in the range of 7.00% - 7.50% by March 2013.

Moreover, the jump in primary food articles inflation (to 9.9% 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, although fuel inflation for March 2012 has mellowed (to 10.4%), 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). Moreover, since the Indian rupee lingering over Rs 50 per U.S. dollar mark, the risk of "imported inflation" creeping in persists.

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 rate cuts along with improvement in the liquidity system is expected to push down yields across maturities of debt instruments. However, while taking exposure to debt mutual funds and fixed income instruments, one should clearly know their investment time horizon.

Since short-term rates are expected to fall due to tight liquidity concerns being addressed to, you can benefit from being invested in mutual funds having exposure to shorter maturity instruments. Hence investors with an extreme 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 short to medium term investment horizon (of 1 to 2 years) may allocate a part of their investments to short-term income funds which should be held strictly with at least 1 year time horizon.

If you have a longer time horizon then you can now gradually take exposure to pure income funds. Since longer tenor papers will become attractive, longer duration funds (preferably through dynamic bond / flexi-debt funds) can be considered, if one has an 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 longer maturity instruments.

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, before the interest rates offered on them are reduced. At present 1 year FDs are offering interest in the range of 7.25% - 9.25% p.a.

 

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