The monetary policy review and changes made by Reserve Bank of India late last month have had mixed reactions from many of the fixed income players. While some of the policy changes made and not made were expected, the hawkish stance now adopted by them has left many of the long-term investments in a grey area, where one is not willing to make an outright prediction on what may or may not happen. However, in the short term, things appear to be a lot clearer with most market experts concurring with RBI?s views and attempts to try and curb excess liquidation while maintaining enough room for the GDP to grow.

?Till now what RBI was basically following was a monetary expansion policy. This was to try and avoid recession setting into the country, and the policy was successful in doing so. However, the current price stability is one of the major concerns that the current policy tries to address. Also, RBI has changed its inflation forecast from 5% which they had anticipated in July this year, to 6.5% and this will be a continuous cause of concern till the rate is under check. The new policy tries to maintain a dual role of keeping both recession and inflation in check. This would require them to maintain the balance between excessive liquidity and tight liquidity. As of now, around Rs 3700 crore cash will be introduced into the system. This way liquidity will hopefully be curtailed to the point where inflation can be kept at bay, yet leaving enough room for the economy to grow? explains YP Narang, head, Fixed Income (debt) Group, Unicon.

Key policy changes

In the new monetary policy changes announced, RBI has left its repo, reverse repo and CRR rates unchanged at 4.75%, 3.25% and 5%. This is pretty much what was expected this October so no surprises there. However, the overall tone of the policy has become hawkish and interest rates may begin to rise from as soon as the last quarter of the FY09-10.

RBI has a pressing worry in terms of inflation; and earlier speculations have given way to fact, as the wholesale price index (WPI) projection changed to ?6.5% with an upside bias? by March end 2010 from ?around 5.0%? earlier. This is a 1.5% change in the projected inflation rate, in just a span of 3 months. While there is little doubt that the inflation is being fuelled by the supply side, RBI feels that the households expected inflation rate will rise over the next three to twelve months. While the concerns over weak rural demand has left people fearing the worst for the overall GDP projections, RBI retained its GDP forecast of 6% with an upward bias for FY10. This has been done on expectations that investment activity in the country picking up pace, and the lagged impact of the recovery in industrial output on the services sectors. RBI has also revised its non-food credit projection to 18% y-o-y in FY10 from 20% earlier, reflecting weak credit demand to date and availability of non-bank funding sources.

Therefore, the monetary policy overall stance has put keeping a vigil on inflation and stabilising inflation expectations as their primary objective.

This monetary policy also saw RBI taking its first steps towards an exit policy. This was done, by terminating the special liquidity facilities ahead of their original March 31, 2010 expiry. They have also hiked the statutory liquidity ratio back to 25% of net demand and time liabilities from 24%, without changing the hold-to-maturity limit and lowered the export credit refinance limit. All of this indicates that RBI is terminating many of its unconventional tools and is now switching more to conventional tightening tools. RBI also said it was worried about excess liquidity resulting in an ?unsustainable asset price build-up? and they have thus increased the standard provisioning for loans to commercial real estate from 0.4% to 1.0%. It also enforced maintenance of the CRR on transactions in collateralised borrowing and lending obligations liabilities.

?We concur with RBI?s growth assessment, but are more worried about inflation, as we expect. We feel that WPI inflation may near 8% y-o-y by March 2010 and average 6.8% in FY11. While growth this year should be subdued at 6.0% due to drought, we expect the virtuous spiral of rising asset prices, improving business and consumer confidence and easier availability of funding to boost GDP growth to 8.0% in FY11. We expect RBI to hike the CRR around December, by a cumulative total of 125bps by the fourth quarter of 2010, given rising inflation expectations and rising net capital inflows. We also expect the policy rate cycle to turn in the first quarter of 2010, with a cumulative total of 125bps of rate hikes in both the repo and reverse repo rates in 2010. RBI has already taken the first step towards a policy exit ? and a smooth and calibrated policy withdrawal will indeed be much better than a steep rate hiking cycle later on? concludes Sonal Varma, Economic Research, Nomura.

Impact

Aneesh Srivastava, chief investment officer, IDBI Fortis Life Insurance Co Ltd explains, ?In light of higher inflation expectations and high liquidity in the system, the policy tone seems hawkish. However, RBI has maintained its stance on key rates given the fact that growth has yet not picked up to a satisfactory level. Increased SLR has led to softening of yields. As the banking system is sitting on a surplus SLR (27% SLR), post this policy we expect the G-sec yields to remain in the range of range 7 -7.5% and the deposit & lending rates will not be impacted by the current policy.?

For any monetary governing body to react effectively and accurately to curb inflation, interest levels and liquidity have to be maintained enough to promote growth and not trip up while juggling all these points in the current world economic scenario is quite a task. This becomes especially difficult when growth rates are yet to reach a stable and acceptable level, the country has just faced a poor monsoon, which no doubt impacts are agricultural growth adversely and hence GDP, and the global economy is still trying to shake off the past 2 years? turmoil. Under the circumstances the current monetary policy has tried to impact as many areas as possible, especially those which require immediate attention. While the stance of RBI has had mixed reactions, one of the sectors which seem to have gotten the raw end of the deal is the banking sector. In a report by Anand Rathi Securities they point out, ?Contrary to widespread expectations of an increase in the HTM (held-to-maturity) limit of banks? SLR investments, RBI considered it undesirable to raise it further. It also increased the provisioning required for standard advances to the commercial real estate sector, from 0.4% to 1%, and stipulated that the NPA provisioning coverage ratio against NPAs (non-performing loans) should be at least 70% by Sep ?10. Banks? gross SLR holdings are likely to rise to 32-33% by Mar ?10, implying that ~30% of banks? investment book would have to be marked-to-market. This is a potential negative for banks and government securities. With the present NPA provisioning coverage lower than 70% for some banks, raising it to this level could squeeze FY11 profitability.?

?However, given the fact that WPI, (which provides a lead for RBI policy action) is still sub 1% awaiting a revision in its benchmarks, RBI has taken a ?wait & watch? stance on the interest rate increase to curb inflation. RBI has also increased its inflation target to 6.5% and has stated that its prime objective would be price stability. Hence, a hawkish approach of RBI in the future cannot be ruled out. RBI may wait for the IIP number next month to get a confirmation on the sustenance of growth or otherwise and a revised WPI number to take any final decision. High liquidity conditions may force RBI to increase CRR in the near term. In anticipation of a higher inflation & high liquidity in the system, the policy tone seems harsh. Special REPO Facilities have been withdrawn. Real Estate loan provisioning has gone up. NPA norms have been tightened and provisioning requirements are increased to keep the credit quality high. Collateralised borrowing and lending obligation (CBLO) borrowing would attract CRR hence the cost of borrowing would go up. Increased SLR has lead to softening of yields. As the banking system is sitting on a surplus SLR (27% SLR), post this policy we expect the G-sec yields to remain in the range of 7 -7.5%, while the deposit & lending rates would not be impacted by the current policy? felt Srivastava as far as the monetary policy impact goes.

Strategies

The current monetary policy changes clearly indicate the direction in which RBI is thinking. With their key issue being to curb inflation while maintaining something for investors in terms if interest rate and keeping enough liquidity in the market, there are some good short-term investment strategies one can use. If the level of inflation does increase for the next one year as expected by some, including RBI, and the monetary policy does help bring it in check by 2010-11, then holding government securities which will try and maintain an interest rate of at least 2-4% above inflation may not be that bad an idea, as far as fixed income investments go. Also, with the yield increasing, the debt market instruments will drop in value and may provide investors a chance to play the interest-rate futures and derivative markets as well.

Maneesh Dangi, head of fixed income, Birla Sun Life Asset Management Company says, ?RBI still considers the trade off between supporting growth and reining in inflation expectations as a ?complex policy challenge?, where as the ?curve? is pricing in a convincing withdrawal of monetary accommodation in the coming months. To be sure, RBI?s endeavor will be to neutralise the rates quickly. India has had an average of 6% policy rate (effective overnight funding rate) in the last decade, and in that context, the current policy setting looks extremely accommodative. But both the sovereign and OIS curves have already priced in rapid-fire rate hikes in the coming months. Thus we believe that most of the curve points would trade in a range in the coming months, with the 10-year benchmark trading in the 7% -7.60% range.?

Narang, who also feels that the current monetary policy is very hawkish in nature, feels that if the liquidity levels are kept under check and the productivity levels are not affected then RBI would have achieved what they set out to. Also with RBI very keen on maintaining an interest rate scenario that is a few percentage points over and above inflation, interest rates may continue to have an upward pressure based on inflation. Hence if one keep a look out for the level of inflation, they can have a fairly good idea as to which direction would interest rates move towards Narang concludes by saying ?Investors should not invest in long-term digit securities and should stick to short-term securities, so as to cut down on the interest rate fluctuation risk. Also, with the current liquidity levels being to the tune of Rs 1 lakh crore, the system should have more than enough money to maintain a growth rate and steady GDP despite the tightening RBI is hoping to achieve to curb inflation.?