The Reserve Bank of India’s (RBI) 13th successive increases in policy rates (since March 2010) in an attempt to tame the inflation bug has now started showing a detrimental impact on the Index of Industrial Production (IIP). While it’s been a rollercoaster ride for the IIP since October 2010, the increase in borrowing cost (due to anti-inflationary monetary policy stance followed by RBI) which has resulted in increasing input costs has led to IIP slump severely.

(Source: CSO, PersonalFN Research)

The above graph clearly reveals that the IIP numbers have been slipping down consistently post the month of June 2011 and now stands at mere 1.9% for the month of September 2011. Interestingly, the 50 basis points (bps) hike brought in by the RBI on July 26, 2011 (the 1st quarter review of monetary policy 2011-12), has not only caused a dent on the IIP numbers, but have also elevated chances of our economic growth rate being below 8.0% for the fiscal year 2011-12.

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	100 bps	6.00%
Statutory Liquidity Ratio	(100 bps)	24.00%
Bank Rate	Unchanged	6.00%

(Source: RBI website, PersonalFN Research)

In the last monetary policy review (held on October 25, 2011) the RBI increased policy rates rather by 25 basis points (bps) to tame the spiraling inflation, thereby signaling its commitment to combat the inflation bug down even at the cost of growth. However, on a softer note the RBI did signal a pause in its rate hike stance if the relevant conditions prevail.

Our View:

The September IIP numbers do show that our economic growth has been under pressure due to the higher interest rate regime in the country. Going forward inflation we believe would remain high at least for the next couple of months as 1.82 increase in petrol prices (brought in with effect from November 1, 2011) may show stickiness, which in turn may lead to a "catch-22" situation for the central bank where they would confront with high inflation on one hand, and slumping industrial growth on the other.

What should equity investors do?

Equity investors should adopt calm and compose approach by staying invested and also investing further as, valuations in the Indian equity markets look fairly attractive and there is potential for robust future growth.

Hence taking a holistic view of the prevailing global and domestic economic scenario we believe that uncertainty will prevail, and thus one needs to be cautious while investing in equities and rather have a staggered approach. Indian equity markets look fairly robust but are susceptible to negative news from the U.S. and Euro zone.

Therefore while investing in equities we think diversification benefit provided by mutual funds can help to reduce risk (however one needs to stay away from U.S. or Euro oriented offshore funds in such a scenario). While investing in equity mutual funds we recommend that you opt for value styled funds and adopt the SIP (Systematic Investment Plan) mode of investing as this will help you to manage the volatility of the equity markets well (through rupee-cost averaging) and also provide your investments with the power of compounding.

Remember, while investing select only those equity funds which follow strong investment processes and systems, and invest with a long-term horizon of at least 5 years.

What should debt investors do?

Well, we think 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. We recommend investors to take gradual 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, provided one has a longer investment horizon (of say 2 to 3 years). 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 FMPs maturing within 5 months. One may also consider investing their money in Fixed Deposits (FDs). At present 1 yr FDs are offering interest in the range of 7.25% - 9.40% p.a.

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