RBI 3rd Quarter Monetary Policy Review 2010-11 – Containing inflation to remain predominant objective

The RBI monetary policy soap opera verdict is out. The mixed global recoveries rather still subdued and the inflationary pressures in emerging market economies (EMEs) including India has been on the top of the radar of RBI in its Third Quarter Monetary Policy Review 2010-11. From the earlier stance of growth-inflation dynamics, the RBI moved to anchor the inflationary expectations likely due to sharp increase in the prices of primary food articles and the recent spurt in global oil prices.

Key Policy Measures:

•  Repo rate, the rate at which banks borrow from RBI, up by 25 bps at 6.5 per cent
•  Reverse repo rate, the rate at which the RBI lends to banks, up by 25 bps at 5.5 per cent
•  Cash Reserve Ratio (CRR), the portion of deposit that banks keep with the central bank retained at 6.0 per cent
• The inflation target revised upwards to 7 per cent from 5.5 per cent for march-end 2011
• The baseline projection of real GDP growth retained at 8.5 per cent with an upward bias.

Domestic Outlook

The domestic economy is on strong trajectory path as revealed by the 8.9 per cent GDP growth in the first half of 2010-11 powered mainly by domestic factors including strong consumption. The strong agricultural output on satisfactory kharif production and higher rabi sowing will contribute significantly to overall GDP growth in 2010-11. The industrial output also showed buoyant figures; however, the significant volatility adds uncertainty to the outlook.

Inflationary Concerns

The headline inflation as measured by WPI remained uncomfortably high since Jan 2010. Although it moderated between Aug and Nov 2010, it reversed in Dec 2010 mainly due to sharp increase in prices of vegetables specially onion, tomatoes, garlic etc and petrol prices. The current inflation level is also contributed by structural demand-supply mismatches in other cereal items. Considering all the scenarios, the baseline projection of WPI inflation for March 2011 has been revised upwards to 7 per cent from 5.5 per cent earlier. The sources of price pressure – fuel and non-fuel commodity prices and some food items could be non-responsive to RBI monetary policy actions. Going forward, the price level will depend how the global and domestic prices evolve.

Liquidity – still in deficit mode

Since the outflows caused due to 3G and WIMAX payments, the liquidity remained in deficit mode in the financial system. Also, the sluggish deposit growth, far below the RBI projection along with the non-food credit growth of 24.4 per cent worsened the liquidity in the system. Meanwhile, the RBI also intervened by cutting SLR by 1 per cent and initiated OMO transactions worth Rs. 67,000 crore. The additional liquidity support to banks up to 1 per cent of NDTL has been extended up to April 08, 2011. Under this, the bank may seek waiver of penal interest purely as an ad hoc measure. The 2^nd LAF will be conducted on a daily basis up to April 08, 2011.

Burgeoning CAD (Current Account Deficits)

The current CAD expected to be around 3.5 per cent of GDP is not sustainable as feared by RBI. CAD, an outcome of net exports and imports may get worsened further if the global recovery improves. Till now, the capital flows, which so far have been broadly sufficient to finance CAD may get adversely affected as the global recovery can trigger the flight to safety.

Global Scenario

There has been a significant improvement in global growth prospects in recent weeks; however, the recoveries are still fragile with uneven scenarios in Euro region and Japan. The deflation fears looming largely on advanced economies got some reprieve with early signs of inflation. The real GDP growth in the US improved to 2.6 per cent in Q3 2010-11 after witnessing a muted growth in 1.7 per cent. The retail sales and corporate capital spending has improved. Unlike in advanced economies, Emerging Market Economies (EME) has been affected by burgeoning inflation trends due to spurt in global food prices including a spurt in crude oil. 

With better signs of sustainable recoveries, the global growth in 2010-11 is anticipated to be less frictional and will show firm signs of sustainable recoveries. With rising prices on increased demand, inflation would be a global concern in 2011.

Why the rate hikes?

The market had been anticipating a tougher stand from RBI as the inflationary issues failed to settle down. While the market had mixed anticipations – 25bps vs 50bps hike, the RBI followed a calibrated approach – hiking the policy rates by 25 bps only – after taking a “comma” stand for few weeks in its policy rate hikes. The current policy rate is still below the pre-crisis level. Since March 2010, it has increased rates by six times. Also, keeping the LAF corridor at 1 per cent, the RBI intended to bring down the volatility in overnight rates within the corridor.

Happy Reading!

-          Amar Ranu

SEBI’s ruling on Mark-to-Market may shun the attractiveness of Ultra-short term funds

Since the SEBI made mandatory for Liquid Fund managers to invest in papers with maturity of up to 91 days only, the Liquid Funds lost sheen among institutional investors due to reduced portfolio returns. This allowed the market participants to shift its focus to Ultra Short Term Funds (erstwhile called as Liquid-Plus Funds). Thanks to superior returns and tax benefits over Liquid Funds, Ultra Short term funds have found a favour among all class of investors.

However, the market watchdog SEBI still not very confident about the credit stability in the market issued another directive asking all mutual funds to value money market and debt securities with maturity over 91 days (or with maturity up to 182-days) on a mark-to-market basis with effect from July 01, 2010. The ruling will require all fund managers to factor in any movement in securities prices on a daily basis to calculate the Net Asset Value (NAV) of fund. The new valuation method may increase the volatility of Ultra Short Term Funds while Liquid Funds being shorter tenure funds will be less volatile. Currently securities having maturities over 182 days are already valued at daily weighted average (mark-to-market) method. The move will ensure that the Liquid Funds and Ultra Short Term Funds are undeniably liquid by asking them to be valued in a more transparent manner.

Ultra short term schemes which comprise 40 per cent of Indian Mutual Fund industry’s asset under management (AUM) of Rs. 7.59 lakh crore have been fetching returns in the range of 5-5.5 per cent having an edge over its sibling Liquid Funds fetching returns in the range of 4-4.25 per cent. The debt instruments held by Ultra Short Term Funds (or Liquid-Plus Funds) have a longer tenure i.e. the average maturity of these funds is comparatively higher than that of Liquid Funds. Long term papers (over 91 days) help fund managers to generate extra returns over short term papers (up to 91 days). Recently the RBI hiked the CRR by 75 basis points which increased the returns on Commercial Papers and Certificate of Deposits by around 100-150 basis points.

In the last few months, there have been continuous net outflows from Liquid Funds due to high dividend tax structure and restrictions to invest in papers having maturities up to 91 days only. Liquid Funds charge a dividend distribution tax (DDT) of 28 per cent unlike in Ultra Short Term Funds where the DDT is 14 per cent for individual and 22 per cent for corporate, thus, clearly giving a tax advantage of 8 per cent. Treasury Officials, CFOs etc prefer Liquid Funds and Ultra-Short Term Funds over Banks’ Fixed Deposits where interest income is charged at 33 per cent.

By issuing out the current directive, the regulator SEBI wants to make sure that the Oct 2008 Credit Crisis is not repeated where the RBI has to open a lending window for Mutual Funds for a limited period to ease out the crisis. However, the industry will continue to enjoy additional returns in Ultra Short Term Funds, though at a slightly higher risk as long as the tax-arbitrage is in existence over Liquid Funds and banks’ Fixed Deposits. The market will actively watch the upcoming Annual Budget on Feb 27, 2010 where the government may take away the tax arbitrage in Ultra Short Term Funds to make sure that Banks’ FDs are actively used for placing excessive unused funds, thus, bringing out a kind of stability in the credit market.

RBI exits from expansionary policies

The domestic economy has started experiencing its feel-good factor with the encouraging numbers from all ends. However, the global economic outlook scripts a different picture. The abundance liquidity, inflationary pressures and week credit off-take forced the central bank to initiate some precautionary steps.

Keeping in mind to provide a balanced approach to our coupled economy, the Reserve Bank of India (RBI) in its second-quarter review of monetary policy 2009-10 maintained its status-quo on its lending and borrowing rates by keeping repo and reverse-repo rates unchanged at 4.75 per cent and 3.25 per cent respectively. It has also kept the Cash Reserve Ratio (CRR), the portion of deposits which the commercial banks need to keep with the RBI unchanged at 5 per cent. However, the bank has hiked the Statutory Liquidity Ratio (SLR), the amount which the commercial banks need to maintain in the form of cash, government approved securities (G-Secs) and/or gold before providing credit to the borrowers, to 25 per cent from 24 per cent effective from Nov 07, 2009 which will suck up over Rs 30,000 crore from the system. The central bank also aims to reduce the surplus liquidity and fight the higher inflationary expectations, which have been building up following a deficit monsoon (22% deficit) causing an increase in prices of food articles and food products.

The RBI has also revised the inflation target from 5 per cent to 6.5 per cent. The inflation has increased from -0.12 per cent to 1.21 per cent within a span of six weeks, thus, reflecting a rise of more than 1 per cent. It has also kept the GDP target unchanged at 6 per cent with an upward bias.

The RBI has responded in a way so that its growth and inflationary targets are met well within their target limits as set and also bridge the fiscal gap by initiating the first phase of its exit from expansionary policy. It has ended the forex swap facility for banks and cut the export credit refinance facility to 15 per cent, the level seen in pre-crisis time from the current level of 50 per cent. It has also ended the special repurchase window for banks, mutual funds and NBFCs with immediate effect.

Following the announcements by RBI, the domestic markets have responded negatively. The barometer Sensex tanked 386 points on profit booking across all sectors except IT companies. The BSE realty index and metals were heavily battered slipping 6.24 per cent and 5.43 per cent respectively. On the debt front, the ten year G-Sec yield slipped from 7.41 per cent to 7.31 per cent, a gain of 0.1 per cent or 10 basis points.