Has Interest Rate peaked out?

We are in a very peculiar situation; equity market is down but gold prices are picking up. Inflation has not been budging down; the liquidity deficit along with the RBI’s ‘calibrated’ turned ‘aggressive’ monetary policies has been driving short term rates. While the Industrial production as measured by IIP nosedived drastically to 1.6 per cent for Dec 2010 from 18 per cent in Dec 2009 mainly due of high base effect and slowdown in industrial activity, the headline inflation cooled marginally to 8.23 per cent, higher than the street expectation of 8.1 per cent. This extreme slowdown in industrial growth may not prevent the central bank RBI to hike the policy rates for another time as the inflation remains stubbornly high.

What other indicators say?

·         10-year G-Sec Bond movement

The G-Sec 10-year yield, an indicator of long-term interest rate scenario in India has been trading below its July 2008 peak when the world markets had been reeling under the immense economic upheavals.  In July 2008, the yield on 10-year note went as high as 9.4 per cent. Due to various accommodative measures announced by RBI, the 10-year note touched to its low of 5.2-5.3 per cent. However, with improved market scenario and increased government borrowing which led to wide gap in fiscal deficit, the bond yield inched upwards to the level 8.23 per cent, but still below the July 2008 level.

·         Short Term rates at its 26-month peak

The interest rates on 3 Months and 12 Months Certificate of Deposits (CDs) – these are short term deposits raised by banks from fellow participants; unlike normal term deposits, these are traded in secondary market – have reached to its 26-month peak on tight liquidity in the system. The liquidity deficit since 3G and WIMAX auctions which led to outflows of over Rs. 1 lakh crore coupled with the government’s high cash balances with RBI and sluggish deposit-credit ratio have led banks tap this market. Short-term rates have continued their upward movement after the RBI started hiking policy rates. The 3M and 12M CD rates have crossed 10 per cent albeit below the level of 2008 economic crisis as given in the graph.

Which is bigger risk for India – Interest rate or inflation?

Many think-tanks say that inflation is a bigger risk in India because the economy becomes haywire because of it. However, this can be dealt with tighter monetary policies albeit in India, the structural and frictional issues are dominant factors in building up the inflation. To a large extent, the RBI has taken protective measures but few more hikes are imminent. The global commodity prices have also been roaring for which the US’s QE II should be blamed. This has affected the local domestic prices too to a large extent.

Moreover, the high fiscal deficit has been worsening. Though in the current financial year, the government has been successful in narrowing down the deficit, thanks to one-time big inflows from spectrum auctions. They might not be successful in future too.

What is expected in future?

The market participants expect massive government borrowing in the next fiscal year to be announced in the upcoming budget in last Feb to meet the increased expenditures which will lead to more bond supply. This will put upward pressure on yields. Also the liquidity deficit which will worsen further on account of advance tax outflows in the current quarter will take the short term rates high further. Moreover, banks have been issuing CDs aggressively to build their large balance sheet size, another reason to boost up the interest rates. Hence, an expected gradual rise in interest rates, given sticky inflation would add to hardening of bond yields.

- Happy Investing!

- Amar Ranu

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

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 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.

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.