RBI Credit Policy Dec 2010 - Implication & Way Forward

The RBI announced its Mid-Quarter Monetary Policy Review today. Key highlights were as follows:

•  Repo, reverse repo rate, and CRR kept unchanged
•  SLR cut by 1% to 24% of net demand and time liabilities (NDTL) of banks with effect from December 18, 2010
• RBI to conduct open market operation (OMO) auctions for purchase of government securities for an aggregate amount of INR 48,000 crores in next one month.

RBI’s Assessment

Global Growth

The western economies have shown better economic data lately. However, unemployment rate has increased in the US and financial stability concerns have resurfaced in Europe. 

Major emerging market economies (EMEs) continue to experience robust growth. However, the RBI notes that despite slow recovery in advanced economies, commodity prices have risen noticeably in recent week. Reflecting this and demand strength, inflation has started rising in most EMEs.

Domestic Growth

With regard to the domestic economy, the RBI observes recovery in agriculture and the recent strong print of IIP in October. Importantly, indicators of industrial and services activity are showing strong momentum.

Domestic Inflation

On inflation, while food price inflation has shown some moderation following a favorable monsoon, inflation for non-food primary articles has risen sharply. Also, non-food manufactured products inflation has risen to 5.4% in November 2010. Furthermore, the RBI notes that rising domestic input costs for the manufacturing sector combined with aggregate demand pressures imply that risk to its projection of 5.5% inflation by March 2011 is on the upside.

Liquidity

While overall liquidity deficit is consistent with policy stance, the RBI observes that the tightness has been beyond its comfort level. This is largely attributable to large government balances, accentuated by structural factors like rise in currency with public as well as relative divergence between credit and deposit growth rates. This huge liquidity deficit can constrain banks’ ability to expand their balance sheets commensurate with the productive needs of the economy. It emphasizes that the liquidity measures taken should be viewed as response to these concerns and not construed as a change in monetary policy stance since inflation continues to remain a major concern.

Interpretation for the Inquisitive Investor

System liquidity including the advance taxes numbers is a negative 45,000 crores. The RBI had already been cognizant of these concerns and had responded lately by infusing approximately INR 22,000 crores via open market purchases of government bonds. However, sections of the market were still anticipating further measures in light of the extreme liquidity deficit. Hence, a further liquidity measure is hardly surprising.

A significant swing can only happen if commodity prices fall by more than 10-15% from these levels especially oil, copper and Steel, thereby reducing inflation pressures and oil bond subsidies and fertilizer subsidies and allowing government to spend at least 80,000 Cr before Feb-march2011.  

Government securities have reacted very positively with yields down between 5 to 10 bps across the curve. Money market yields are down some 10 bps on the back of initial relief on liquidity.

• Going forward, market will look to take cues from the securities selected for the OMOs as well as from the cut-off yields awarded in the actual operations.
• Corporate bond yields are unlikely to fall given the pressure of supply.
• Money market rates are also unlikely to come-off significantly since overall liquidity deficit as well as pressure of issuances will continue into March. So liquid plus funds could continue delivering 6.8% annualized returns
• Short term bond funds could get hit as the rise in yields and spreads is a dampener on bond performance, but then if funds continue to flow into them like Templeton India Income Opportunities Fund they could go on a accrual phase and start giving returns in excess of 8% for the next two years.
• Macro environment does not seem to be very positive for duration bonds especially looking at a commodity price spike happening.
• Risk versus reward favors exposure to the front end of the curve, like 6 months to 18 months max. (FMP)
• On the whole I think the current phase is one of pause in an overall rising interest rate cycle.