RBI Mid-Sept Monetary Policy Review – Loans to become dearer

The hawkish global economy recovery coupled with high inflationary pressures forced the Central Bank to raise Policy Rates at the pace faster than the market expectations. The Central Bank, RBI in its Mid-Quarter Monetary Policy Review increased the repo rate and reverse repo rate under LAF.


• Repo Rate and Reverse Repo Rate under Liquidity Adjustment Facility (LAF) increased by 25 bps and 50 bps to 6 per cent and 5 per cent respectively, thus, bringing out the LAF rate corridor to 1 per cent.
• Bank Rate and CRR (Cash Reserve Ration) retained at the same level of 6 per cent each

Domestic Scenario
The RBI stressed on that fact that Inflation has become a kind of concern; even the new index of headline inflation as measured by WPI suggests that the monthly average of WPI inflation for Q1 of 2010-11 under the new series at 10.6 per cent was about 50 bps lower than the rate of 11.1 per cent under the old series. Inflation rates have reached its peak and are most likely to remain at the same level for the next few months. However, Food Inflation continues to move northwards and touched 14 per cent in Aug 2010 as per new series.

Another concern that the RBI documented that the negative real interest rates have been affecting deposit growth rates of banks as savers look for higher returns elsewhere. The RBI wanted deposit growth rates to increase as accordingly the bond supply will be a thorough affair in its weekly auctions without any devolvement which may put pressure on yields. The trend suggests that higher deposit growth rate require higher demands for federal bonds as the bank need to maintain the SLR requirement.

The RBI also indicated that higher than expected realizations on 3G and BMA auctions combined with robust tax revenues have virtually eliminated the risk of the fiscal deficit overshooting its target of 5.5 per cent, even after the additional demand for grants from the Central Government have come up in the Parliament. The Water God, Monsoon has revived the growth prospects in Agriculture which will contribute to good rabi harvest.

Liquidity – from a large surplus to deficit
From a surplus mode, the liquidity entered into a deficit mode after the July Policy review, thus, making the repo rate as the operative policy rate. The current hike will prompt many banks to raise the lending and deposit rates which will sustain the strength of the transmission mechanism.

Global Factors
The RBI remained elusive of global circumstances where the slow recovery has halted many advanced economies to hold their rates further for an extended period. This led to massive inflows into developing economies including India. Moreover, the weak global demand coupled with strong domestic demand has increased the trade deficit and the current account deficit has also been widening. However, Europe has demonstrated remarkable resilience; China too bounced back with industrial production and trade numbers reviving sharply. “Overall, even as the global environment continues to be a cause for caution, the big picture has not worsened significantly since July”, said RBI in a press note.

Need for the hike in Policy Rates
Though the hike in policy rates were expected but by increasing the Reverse Repo Rate by 50 bps, higher than the market expectation of 25 bps, the RBI has used this opportunity to reduce the LAF rate corridor, which will reduce the expected volatility in overnight rates. Moreover, it also wanted to reduce the impact of negative real interest rates which led to savers to move to alternate products giving higher returns.

Yields to take cues from Inflation and Policy meet

Highlights:

• The bonds remained jittery throughout the week; however, it settled down at low levels as compared to last week closures.

• The Industrial Output Data as measured by Index of Industrial Production (IIP) rose a more-than expected 13.8 per cent in July 2010, or nearly twice the 7.2 per cent seen in last month.

• Retail Inflation and Food Inflation rose over 15 per cent and 11 per cent, causing a concern for RBI which may hike the rates again.

• The market liquidity remained comfortable with the net absorption of Rs. 27,640 crore under LAF window. However, it would remain in deficit mode going forward.

• The market speculation that the current benchmark paper will be replaced have been put on hold after a Senior Finance Ministry official stated that there is adequate headroom in the current 10-year paper and the bond is expected to last for the entire borrowing in FY11.

View & Recommendations:

• The unexpected factory output at 13.8 per cent plus the high inflation figures may prompt the central bank RBI to revise the policy rates upwards. However, the market has already factored into the 25-bps hike in policy rates.

• Bond yields may soften further in view of global economic environment especially from US i.e. better than expected US Employment data.

• The absence of debt sale in the coming week will keep the demand for debt papers high. The real tone will be set after the mid-quarter policy review this week. Any positive surprise will be greeted with a rally in bond prices. The market is likely to focus on domestic data and policy measures. The policy meet will also review the awaited headline inflation figure due on Sept 14, 2010.

Broader Perspectives:
Bond Front
It is concerned that policy makers are running out of ammunition to control inflation and high factory output is also reigning in strongly; the RBI may go for an upward hike in policy rates. However, the mixed sentiments emanating from global markets are preventing RBI from taking any extreme measures. US President Barack Obama commented that US economy was taking longer than expected time to recover from economic shivers. However, the better-than-expected growth in US employment increased the odds of a fifth interest-rate hike this year.

Bond prices moved up with the 10-year benchmark yield witnessing a drop of 7 bps. The benchmark bond 7.80% 2020 yield nosedived from 7.98 per cent to 7.91 per cent. The comment by the Senior Finance Ministry over the continuance of the current 10-year benchmark bond for the remaining fiscal year 2010-11 boosted the sentiments among traders and investors which lapped the bond to make the prices attractive. He added that the government's preference was to borrow through papers of longer maturity, in order to evenly spread out its outstanding. However, the 8.13% G-Sec 2020 eased only 1 bps to 8.04 per cent. The G-Sec volume was also strong as reported in NDS-OM platform; it showed a daily average of Rs. 12,353 crore over the week. The 1-10 year spread also reported a sharp drop from 168 bps to 149 bps.

Bond Supply
The government auctioned securities worth Rs. 11,000 crore last week. The bonds auctioned were the 7.17% 2015 for Rs. 4,000 crore, the 8.13% 2022 for Rs. 4,000 crore and the 8.26% 2027 for Rs. 3,000 crore respectively. The cut-offs were in line with the market expectations which came in at 7.69 per cent, 8.02 per cent and 8.35 per cent. Five State Governments namely Maharashtra, Punjab, Tamil Nadu, Uttar Pradesh and West Bengal conducted the auction of their State Development Loans for combined amount of Rs. 5,300 crore on Sept 07, 2010. Their cut-off yields were in the range of 8.29 per cent to 8.41 per cent.

Liquidity
The liquidity was comfortable throughout the week as measured by bids for Repo and Reverse Repo auctions in Liquidity Adjustment Facility (LAF). The net absorption amount was Rs. 27,640 crore for this week. This week, there won’t be any auction which will ease off the liquidity. However, the advance tax outflow to the tune of Rs. 50,000 will put the liquidity in deficit mode. The average Call and CBLO rates dropped to 4.65 per cent and 4.28 per cent from 4.77 per cent and 4.75 per cent respectively over the week.

Corporate Bonds
Corporate bonds’ yields fell over the week. The 10-year AAA bond ended at a yield of around 8.71 per cent compared to 8.75 per cent. However, the 1-year bond hardened by 15 bps to 7.95 per cent from 7.80 per cent a week earlier. In the primary market, EXIM Bank raised Rs. 100 crore with 5-year paper and another Rs. 100 crore with 10-year paper with an annualized yield of 8.45 per cent and 8.68 per cent.

IRDA regulations – Policyholders to be benefitted

The recent spat between IRDA, the Insurance Regulator and SEBI, the Capital Market Regulator created an outcry in the market with each party holding its supremacy over the much sought and widely circulated insurance product, Unit Linked Insurance Products (ULIPs) in India. The Government of India in quick solution passed an ordinance to support the IRDA regulation over ULIPs ending the market speculation that SEBI might make Ulips in line with Mutual Funds.

Fresh from its victory in the regulatory turf war over ULIPs, the IRDA announced a set of regulations. With the expansion of insurance sector and more innovative insurance products, particularly Unit Linked Insurance Products (ULIPs) entering into Life Insurance products list, IRDA has been sensitive to the changing scenario. In the past, IRDA has come out with various steps to bring in changes in the regulatory framework to address various concerns of the policyholders.

IRDA in a note stipulated that insurers must provide the prospect/policyholder all relevant information regarding amounts deducted towards various charges for each policy year so that the prospect could take an informed decision. IRDA also raised the concerns of mis-selling and Distance Marketing which require guidelines from the insurance regulator. Further, IRDA set up an exclusive Customer Affairs Department that focuses on consumer related issues and initiatives including grievance redressal and consumer education through Insurance Awareness Campaigns. It is perhaps the most important step in the interests of policyholders.

Recent Regulatory Proposals

ULIPs are hybrid instruments that combine elements of mutual funds and insurance. In most cases, the insurance amount is capped to 5-times of initial insurance premium. Recently, IRDA came out with guidelines governing ULIPs – how such products are sold/bought; how ULIPs can be better financial instruments for providing risk coverage and many more. Some of the ULIPs related regulations are as given below:

1) Level Paying Premium

All regular premium /limited premium ULIPs shall have uniform/level playing premiums. Any additional payments shall be treated as single premium for the purpose of insurance cover.

2) Compulsory Cover

Currently there are a number of ULIPs schemes where there is maximum insurance cover up to five times of the premium paid or no insurance cover. Now it has been recommended that the life insurance component has to be at least 10 times the premium paid for policies up to 10 years and at least 1.05 times the annual premium for policies of 20 years and above.

3) Lock in Period increased to Five Years

IRDA has increased the lock-in period for all ULIPs from three years to five years, including top-up premiums, thereby making them long term financial instruments which basically provide risk protection.

4) Minimum Premium Paying term of Five Years

All limited premium ULIPs, other than single premium products shall have premium paying term of at least five years

5) Even Distribution of Charges

Charges on ULIPs are mandated to be evenly distributed during the lock-in period, to ensure that high front ending of expenses is eliminated.

6) Pension Plans to have Guaranteed Return

As regards pension products, all ULIP pension/annuity products shall offer a minimum guaranteed return of 4.5% per annum or as specified by IRDA from time to time. This will protect the life time savings for the pensioners, from any adverse fluctuations at the time of maturity.

7) Rationalization of Cap on Charges

With a view to smoothen the cap on charges, the capping has been rationalized to ensure that the difference in yield is capped from the 5th onwards. This will not only reduce the overall charges on these products, but also smoothen the charge structure for the policyholder.

Though these regulations have been rolled out for the benefit of common policyholders, the insurers will have a level playing field with other players and will benefit in the long run.

Yields to fall – Focus on Income Funds

Inflation has started coming down. WPI, the official figure for measure of Inflation came down to 9.97 per cent, 0.03 per cent shy of two digits. The RBI concern on ballooned inflation, a shift of focus from growth to inflation led to a series of monetary policy measures this year, already four times witnessed. More worrisome is the fact that the inflation is no longer food prices driven; in fact it has become more generalized. Non-food inflation has risen from almost zero level in Nov 2009 to 10.9 per cent in June 2010, contribution 70 per cent to inflation.
The bond yields rose abruptly in India, however, the bond yields came down globally. For the first time in its history, the 10-year Indian and US bond yields are facing a divergent state.

The G-Sec markets witnessed hardening of yields in July and Aug 2010. The 10-year G-Sec Bond and Short Term Bonds’ yields have spiked in the recent past; which we believe that they may go up further projected the advance tax outflows in Mid September. The short term yields (1-year CD and CP) have already spiked by 200 bps in the last 3 months. The benchmark bond 7.80 per cent 2020 has already touched 8.08 per cent, currently hovering at 8.03%. It touched its four months high since May 2010. The RBI is still not comfortable with the inflation figures and the market opines that it may go with further rate hikes in the upcoming Monetary Policy meet due in mid-Sept.
We believe that the G-Sec yields in long term will follow its logical course of softening. The reasons are:
• Softening of inflation in coming months
• Improvement in Government revenues in the form of improved tax inflows, 3G and WIMAX auctions
• Reduction in fiscal deficit, if the excess revenue is used efficiently
• Spread in the Repo rate and 10-year G-Sec rate (already at multiple year high) should reduce
• Liquidity is bound to improve; temporarily we might witness liquidity deficiency in the system
• For the first time since 2002, interest rates in India are divergent to US yields (Check the above table)

Since US government continues to follow an expansionary monetary policy to revive growth, the Fed has kept its interest rates abysmal low for another extended period. However, in India, RBI has shifted its focus from good GDP/IIP growth to inflation management; therefore, we witnessed tightening of monetary policy. When inflation comes under control over next few months, bond yields (long dated bonds) will follow its logical course of softening. For those seeking to ride the yield curve at the longer end which could potentially ease in the 2nd half, we would recommend allocations to Income Fund having high average maturity. In the above stated scenario, the income funds stand to benefit with a time horizon of 12 to 18 months.