Staying firm on its stance, RBI kept key policy rates unchanged at its fifth-bi-monthly monetary policy review. Falling inflation had given rise to expectations that RBI may provide some relief to borrowers by slashing policy rates. The Finance minister too made a case for rate cut and opined that it would provide an incentive to economic growth.

But maintained a status quo based on its macroeconomic assessment, liquidity situation in the system, trends in inflation along with inflation expectations and fiscal management of the Government among other factors. PersonalFN brings to you in depth analysis.

Macroeconomic assessment:
Since the fourth bi-monthly monetary policy was announced in September, global economic recovery has decelerated. There has been a downside pressure on some of major emerging economies. High inflation, low commodity prices, labour market problems and stagnating domestic demand remained the key risks. On the other hand, broad based recovery gathered pace in the U.S. thanks to rising investments, strong domestic consumption and revival in the industrial activities. On similar lines, growth in japan looked promising on strong exports. Quantitative and qualitative measures announced by Japan helped the nation record impressive exports, but also led to depreciation of the Yen.

Speaking about India, Gross Domestic Product (GDP) growth remained dull. As against the 5.2% growth in the Q2FY14; India's GDP advanced by only 5.3% in Q2FY15. Lacklustre performance of manufacturing industries and muted growth in mining sectors dragged growth. On the other hand, service sectors such as Finance, Real Estate, Insurance and Community and social services which together account for nearly 37% of the overall GDP, grew at a rate in excess of 9.5%, providing support to overall growth. Industrial growth measured by the movement of Index for Industrial Production (IIP) continued to depict a see-saw movement and remained rather unimpressive.
 

Is worst over on the inflation front?

(Source: Office of the Economic Advisor, PersonalFN Research)

On back of some of the transitory factors such as favourable base effects and seasonal fall in the prices of fruits and vegetable, which is usually around this time of the year; retail inflation (measured by CPI) fell consecutively in September and October. Softened crude oil prices too have aided inflation to mellow down. However, RBI has highlighted that, rising prices of protein rich items such as milk and pulses expose the demand supply mismatches, giving hints of structural problems. In the non-food segment there are upside pressures as well. Although, inflation expectations have come down as a result of softening of fruits and vegetable prices and falling crude oil prices internationally, the outlook may change drastically. If administered prices of electricity among others key inputs correct,, inflation may go up. There are several other factors that may significantly alter the current benign trend in inflation; they include possibility of weaker than expected agricultural output and possibility of reversal in crude oil prices due to several geo-political risks.

Liquidity Situation
Liquidity conditions have improved in the Q2FY15 and trend seems to be continuing in Q3FY15 as well. You see, in Q1 of the current fiscal, daily average borrowing by banks under different liquidity windows including net fixed and variable rate, term and overnight repos and Marginal Standing Facility (MSF) stood at Rs 80,300 crore. This borrowing declined to Rs 70,600 crore on an average in Q2. And in the first two months of Q3 (i.e. in October and November) banks have borrowed about Rs 47,600 on an average. Factors that have contributed in easing liquidity pressures include:
 

• Deposit growth exceeding credit growth
• Liquidity injected by the Government by way of expenditure and transfers
• Revised liquidity management framework introduced in September helped arrest volatility in borrowing rates for banks and also brought them in line with the repo rate
   

Policy Rationale
The RBI preferred to remain cautious rather than over optimistic on inflation. While headline inflation has receded steadily and are below the January 2015 target of 8.0% as well as the January 2016 target of 6%...and the inflation for November 2014 too is likely to further soften; the favourable base effect that is driving down headline inflation will likely dissipate and inflation for December may well rise above current levels. The risks from imported inflation (i.e. inflation of goods imported in the country) according to RBI is retreating given the softening of international commodity prices, especially crude, and reasonable stability in the foreign exchange market.; it is sceptical about the food price inflation. As per the assessment of RBI, there are several upside risks to food inflation stemming largely from loss of Kharif crops due to lower than normal monsoon and unlikeliness of Rabi crop compensating for the decline in Kharip crop. Although RBI has revised the inflation forecast for March 2015 to 6%; it has also not ruled out escalation of inflation on account of aforementioned factors.

Monetary Policy Action...
Hence in the backdrop of the aforementioned macroeconomic assessment, it was decided by RBI as under:
 

• To keep the policy repo rate unchanged 8.00%; and
   
• To keep the reverse repo rate unchanged at 7.00%
   
• Bank rate at 9.00%
   
• To keep the CRR of scheduled banks unchanged at 4.00% of net demand and time liability (NDTL).
   
• Continue with daily one-day term repos and reverse repos to smooth liquidity.
   

The central bank also decided to ...
 

• Continue to provide liquidity under overnight repos at 0.25 per cent of bank-wise NDTL at the LAF repo rate and liquidity under 7-day and 14-day term repos of up to 0.75% of NDTL of the banking system through auctions;
   

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 would infer borrowing cost of commercial banks would remain at the same level as earlier. Hence as a reaction to such a move cost of borrowing for individuals and corporates may also remain elevated, thereby keeping home loans and car loans yet expensive.

The reverse repo rate is the rate of interest, at which the banks park their surplus money with the central bank. Increasing the repo rate will imply that commercial banks would enjoy the same rate of interest as earlier, for parking their surplus funds with RBI.

The CRR is the amount of liquid cash which the banks are supposed to maintain with RBI. Keeping it unchanged would not infuse further primary liquidity into the banking system. Likewise keeping the MSF rate would not infuse short-term liquidity in the system. But, through the 7-day and 14-day term repos, the RBI has addressed to very short-term liquidity concerns.

Guidance from monetary policy and path for interest rates:
At present, retail inflation has been well below target of 8% set for 2015; and also lower than the 2016 target of 6%. The inflation for November (which would be available mid-December) is expected to be even lower due to favourable base effect. However, as mentioned earlier, the central bank expects December inflation (would be available mid-January 2015) to be higher than the current level.

RBI is of the view that, there is enough room to doubt durability of the current trend of disinflation and various groups including industrial bodies, investors and consumers may have gone overboard with expectation of lower inflation going forward. For this reason, RBI believes, cutting policy rates would be premature at this juncture. Having said this, the central bank has tried to address uncertainty pertaining to future policy stance. The RBI has stated that, once the monetary policy stance changes, policy actions thereafter would be consistent with the changed stance. In other words, if RBI starts cutting rates, it may adopt accommodative policy thereafter.

Going one step ahead, RBI has also suggested a likely change in the policy stance early next year, including outside the policy review cycle. However, it has attached several conditions for doing so. They include, downtrend in inflation should continue even in future, expectations of inflation remain lower and fiscal developments should be positive.

RBI's projection of GDP:
The RBI has reaffirmed the 5.5% GDP estimates for the current fiscal while growth is expected to gradually pick up in 2015-16. For next quarter including one under progress, RBI expects Indian economy to grow better than that in Q2 and finally recording higher growth in Q4. Disagreeing to the largely held belief that higher borrowing cost is affecting the capex cycle, RBI has indicated that infrastructural constraints and lack of assured supply of key inputs in particular, coal, power, land and minerals have been the main causes of sluggishness in the capex.

The RBI remains hopeful about the efforts of Government to resolving long standing issues that are delaying the capex growth. The RBI also expects the Government to exert efforts for compensating for downside risk to growth in agricultural output and sagging exports. The GDP estimation of RBI is based on assumption of normal monsoon in 2015.

Impact on debt markets...

Debt markets remained firm and optimistic about the future course of policy stance. Investors have now started anticipating a rate cut early next year assuming that current downward trend in inflation, and if that continues and Government remains committed to curbing fiscal deficit, it may add buoyancy to the debt market. On the day of policy review, Indian bonds staged a rally and yield on India's 10-Year benchmark sovereign bond fell to a 16-month low. The yield currently stands at 8.01%. Indian rupee remained firmed too.

What strategy should debt investors should adopt?

PersonalFN is of the view that, bond markets may remain optimistic about the rate cut, going forward. Therefore one may see buoyancy in the Indian debt market. Bond investors would track a few events such as inflation, rupee strength, progress of Government in containing fiscal deficit and developments on reform fronts to name a few. If broadly these factors stay positive going forward, further easing of yields can't be ruled out. The announcement in the Union Budget 2015-16 would also have some cues for bond investors.

Having said this, PersonalFN believes, in case any of the macro-economic indicators affecting the decision of RBI turns unfavourable, bond rally might retreat. For any reason, RBI doesn't cut policy rates early year, bond yields may move up.

PersonalFN has always believed that, investors shouldn't speculate on the direction of interest rates and invest in debt funds; instead, you should look at your time horizon before committing money to debt funds.

Since RBI has suggested that, whenever policy stance reverses, further actions would be would be consistent with the changed stance. Besides, the liquidity conditions in the system are comfortable. For these reasons, longer end of the yield curve looks more attractive than the shorter end of the curve. But while you do so, ensure that your exposure to long term debt funds does not exceed 20%-25% of the entire debt portfolio. While G-sec funds may start delivering returns as fundamentals improve and policy rates start to relax, going overboard now may not be very prudent. Fixed Maturity Plans (FMPs) can also be considered as an option to bank FDs only if you are willing to hold it till maturity ideally over 36 months, though they now do not enjoy a favourable tax status post budget 2014-15.

In case you have a time horizon of less than a year, you should still stay away from funds with longer maturities. So, if you have a short-term investment horizon of 3 to 6 months you could consider investing in ultra-short term funds (also known as liquid plus funds). And if you have an extreme short-term time horizon (of less than 3 months) you would be better-off investing in liquid funds. Alternatively, if you are risk averse you can also invest in Fixed Deposits (FDs) now at high interest rates before banks pull down deposit rates.

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mci4k2qr@yahoo.com Jan 07, 2015 That takes us up to the next level. Great post.

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