Review of First-Quarter Monetary Policy & Debt Fund Investment Strategy Policy Review

July 31st , 2012

Prateek Jain

31st July, 2012

Inflationary pressures overrides downside risks to growth

Amit Rawal

prateeku.jain@jmfinancial.in 91-22-3022-7019 amit.rawal@jmfinancial.in 91-22-3022-7016

Key Highlights:
Repo Rate left unchanged at 8%. Thus, reverse repo rate and marginal standing facility (MSF) rate stand unchanged at 7% and 9% respectively. CRR left unchanged at 4.75%. To ease liquidity and channel the funds to productive sectors the RBI has reduced the SLR from 24% to 23%. The baseline projection for WPI inflation for March 2013 has been raised from 6.5%, as set out in April Policy, to 7%. The GDP growth projection for 2012-13 has been revised downwards from 7.3% to 6.5%.

Policy Stance:
The RBI in its First-Quarter Review of Monetary Policy, in line with market expectations, has kept policy rates unchanged. After surprising the markets with higher than expected repo rate cut of 50bps in April policy, RBI has maintained a hawkish stance since June. The sticky nature of inflation and inability of government to address fiscal concerns are sighted as the main reasons to maintain status quo on policy rates, in consistence with the last policy. Despite the slowdown in GDP growth rates, inflation continues to be at elevated levels. The stubborn inflation numbers have largely been the function of rise in primary food articles and given the rainfall deficiency in the current monsoon season, the upside risks to inflation has further increased. RBI has also highlighted the emerging risks to non-food manufactured products (core) inflation due to input price pressures. Given the inflationary pressures and the inaction from the governments part to address fiscal concerns, has led RBI to maintain its priority towards containing inflation and lowering inflationary expectations. The RBI is of the view that, In the current circumstances, lowering policy rates will only aggravate inflationary impulses without necessarily stimulating growth. Further, the RBI has cut the SLR rate from 24% to 23% to address liquidity concerns and also to ensure that private sector is not crowded out from the credit markets. The decision to cut SLR, when the government is running high fiscal deficits may lead to RBI using OMOs as an active liquidity management tool and also to ensure the smooth completion of governments borrowing calendar. Rising inflationary pressures and the fact that RBI does not see monetary policy as a potent tool in current circumstances to address growth concerns are the main factors shaping policy stance. Apart from the large fiscal deficit, the quality of expenditure is also a cause of concern. Major part of the borrowing is used to fund subsidies and other flagship social programmes that stoke inflation. Going ahead we believe policy stance will not only be formed by expected inflation trajectory but also by the steps taken by government to mitigate fiscal concerns.

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Policy Stance on July 31, 2012
Against the backdrop of heightened global uncertainty and domestic macroeconomic pressures, monetary policy will maintain its priority of containing inflation and lowering inflation expectations continue to provide liquidity to facilitate credit availability to productive sectors.

31st July, 2012

Policy Stance on June 18, 2012
The Evolving growthinflation dynamics will influence stance on interest rates Fiscal consolidation critical for inflation management Management of liquidity remains a priority.

Policy Stance on March 16, 2012

stabilise growth around its current post-crisis trend contain risks of inflation and inflation expectations resurging Enhance the liquidity cushion available to the system.

Policy Stance on January 24, 2012

As indicated in the TQR, the slippage in the fiscal deficit has been adding to inflationary pressures. Credible fiscal consolidation, therefore, will be an important factor in shaping the inflation outlook. Upside risks to inflation have increased from the recent surge in crude oil prices, fiscal slippage and rupee depreciation.

Financing fiscal deficit from domestic saving crowds out private investment, thus lowering growth prospects. Failure to narrow deficits with appropriate policy actions threatens both macroeconomic stability and growth sustainability. Lowering policy rates will only aggravate inflationary impulses without necessarily stimulating growth.

The subsidy burden on the Government is crowding out public investment at a time when reviving investment, both public and private, is a critical imperative. Further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures.

However, it must be emphasised that the deviation of growth from its trend is modest. At the same time, upside risks to inflation persist. These considerations inherently limit the space for further reduction in policy rates. Moreover, persistent demand pressures emerging from inadequate steps to contain subsidies as indicated in the recent Union Budget will further reduce whatever space there is.

Recent growth-inflation dynamics have prompted the Reserve Bank to indicate that no further tightening is required and that future actions will be towards lowering the rates. However, notwithstanding the deceleration in growth, inflation risks remain, which will influence both the timing and magnitude of future rate actions.

Source: RBI documents

Macro Indicators:
Factors GDP Inflation Current Previous Estimates Estimates for Remarks for FY13 FY13 6.5% 7.3% Deficient & uneven monsoon, weak industrial activity and increasing external risks are key factors intensifying the risks to economic growth. 7.0% 6.5% Risks to inflation remain from unsatisfactory monsoon, increases in MSP, elevated crude oil prices, and Infra bottlenecks in coal, minerals & power. While core inflationary pressures are currently muted, a continued rise in real wages may spill over to core inflation. Projections for monetary indicators have been kept 17% 17% unchanged. SLR cut by RBI is with a view that liquidity pressures do not constrain the flow of 16% 16% credit to the productive sectors of the economy. 15% 15%

Credit Growth Deposit Growth M3

Source: RBI Policy documents

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Impact on Debt Market & Strategy:

The status quo maintained by RBI was in line with market expectations however the hawkish policy stance with a commitment towards firmly containing inflation & inflationary expectations, despite the increasing downside risk to economic growth, had a negative bearing on the markets. The policy stance has dented the expectations of rate cuts in the near term given the upside risks to inflations, thus exerting upward pressure at the longer end of the yield curve. The 10yr benchmark security moved up by 11 bps from 8.14% to 8.25% post the policy announcement. The shorter end of the curve remained flattish despite liquidity alleviating measures by RBI in the form of SLR cut. With current SLR ratio at 30.5% (as of July 13, 2012, source: RBI), there are expectations that SLR cut may not have much of impact however on the contrary, it increases the lendable resources for the banks by more than Rs. 62,000 crs, which can potentially reduce pressures on lending rates as well as on systemic liquidity. Current Yield (%) 10Yr Gilt 12M CD 12M CP 12M T-Bill 12m OIS 3M CD 3M CP 3M T-Bill 3m OIS 8.25 9.11 9.88 7.95 7.71 8.76 9.33 8.13 7.94 Previous day closing (%) 8.14 9.14 9.85 7.95 7.65 8.76 9.31 8.13 7.83
Source: Bloomberg

Change in bps 0.11 -0.03 0.03 0.00 0.06 0.00 0.02 0.00 0.11

Longer End: The status quo by RBI coupled with future guidance not signaling at immediate rate cuts led to a sell off in the long bonds, reversing the gains over the last 15 days or so in expectations of dovish policy guidance. Adding to the woes was reduction in SLR by 1%, which reduces the demand for govt bonds by banks. Near term pressure at the longer end may continue on the back of a) gross supply of 1.21 lac crs & state borrowing of aprox Rs. 25,000 crs in the next 2 months and b) sticky inflationary expectations & inflation biased policy stance reduces the expectation of rate cuts in the near term. However, RBI in its policy review reiterated its willingness to resort to OMOs and any move akin to 1H could provide support to yields at the longer end. Additionally, if any incremental measures are taken by govt to address fiscal & supply side concerns, the RBI will have the elbowroom to reduce rates to address below trend growth rates. These factors could possibly play out over the long term favoring the longer end of the curve. Having said that aggressive investor having appetite for intermittent volatility may look at staggered investments into duration funds with an investment horizion of more than 15 months. Shorter End: The RBI continues to lay thrust on liquidity management to facilitate smooth flow of credit to productive sectors to support growth, implying that the central banks wishes to have liquidity in the comfort zone. The same is reflected in the LAF window wherein the net repo bids have fallen from an average of Rs 90,000 1,00,000 crs to below Rs. 50,000 crs within the +/-1% of NDTL range proposed by RBI. Additionally, steps like SLR cut by 1% and moderating credit growth is liquidity enhancer in the long run. With improving liquidity conditions and lower overnight rates (tracking repo at 8.0% levels), the short term yields may ease further, providing continued opportunity for the short term income funds.

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Given the near term headwind for the longer end of the curve, the shorter end continues to be favorably placed both from the point of view of building an accrual based portfolio and also for the investor looking for MTM gains with a medium term horizon. The key risk to structural improvement in liquidity is - if RBI intervenes aggressively in forex market, and the revival in credit growth in H2 FY12 leading to widening wedge between deposit growth and credit growth.

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Disclaimer
This document has been prepared for your information only. In rendering this information, we assumed and relied upon, without independent verification, the accuracy and completeness of all information that was publicly available to us. The information has been obtained from the sources we believe to be reliable as to the accuracy or completeness. This should not be construed as an offer to sell or buy the securities and the information contained herein is meant for the recipient only and is not for public distribution. This information is given in good faith and we make no representations or warranties, express or implied as to the accuracy or completeness of the information and shall have no liability to you or your representatives resulting from use of this information. We shall not be liable for any direct or indirect losses arising from the use thereof and accept no responsibility for statements made otherwise issued or any other source of information received by you and you would be doing so at your own risk. The investment as mentioned in the document may not be suitable for all investors. Investors may take their own decisions based on their specific investment objectives and financial position and using such independent advisors, as they believe necessary. Investment in Mutual Funds is subject to market risks. You are advised to carefully read the offer document and go through all the Risk Factors mentioned in the offer document issued by the Mutual Fund before investing.

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