By Pankaj Pathak
As Reserve Bank of India (RBI) is going to announce its monetary policy on June 6, the street has priced for at least 25 basis points reduction in the policy repo rate. Furthermore, there is also a call for change in liquidity stance by RBI to cool off the money market which has been under pressure since the IL&FS defaulted on its debt obligations in September last year.
The market’s demand for monetary easing seems justified in the wake of persistently benign inflation trend and big drop in the crude oil prices. However, the bigger question would be whether the monetary policy committee (MPC) of RBI will continue to focus on its inflation mandate as its primary objective and put a restraint on the extent of rate cuts or will it make a larger move to reignite the animal spirit in the economy.
Slowdown in economy
Economic activity has been gliding south for last two quarters. Domestic consumption, which is widely considered as a major force behind the India growth story, is showing signs of slackness. High frequency indicators like automobile sales, FMCG volumes, consumer durable productions, etc., are trending down. The GDP growth numbers in the last two quarters are also confirming this trend. There is a long list of culprits among which rural distress, unemployment and crisis in the non-banking finance companies (NBFC) top the chart. The situation clearly calls for a multi-front policy intervention from both RBI and the government.
The central bank has already cut policy rates twice from 6.5 to 6% and has infused over `2 trillion of durable liquidity through Open Market Purchase (OMO) of government bonds and long-term USD/INR swap since start of this year. But it has failed to make a notable impact on the credit markets. We believe this credit crunch is mainly due to investors’ trust deficit over the financial position and asset quality of non-bank lenders. Thus an aggressive liquidity infusion may not necessarily translate into easy availability and lower cost funding for the NBFCs. Nonetheless it may help in transmission of the earlier rate cuts and reduce cost of credit in the system.
Consumer inflation has been benign for last three quarters though much of it has happened due to unusual fall in food prices. At current levels, the food inflation looks unsustainable for the agricultural economy. We are already getting supply side response with reduced sowing in the last two cropping seasons.
We expect RBI will once again reduce the repo rate by 25bps or can surprise the markets positively with some higher quantum. However, it might maintain its primary objective to tackle potential inflation risks that could limit the scope of rate cuts to maximum 50 bps. At this point we do not see a large rate cutting cycle.
Yield on the 10-year government debt is down from 7.4% in April to below 7% now. It might move further down though sustaining there looks difficult considering the limited scope of rate cut.
Investors in bond funds should keep these macro risks in mind while trying to benefit from the falling bond yields. Dynamic bond funds, which allow the fund manager the flexibility to change the portfolio positioning depending on the emerging situation is a better alternative than long duration funds for the investors who wish to allocate to bond funds and can have a holding period of 2-3 years.
Investors with low risk appetite should stick to liquid funds or other short maturity debt funds to avoid any sharp volatility in their portfolio value. However, while choosing such funds one should be aware of the credit risk and prefer funds which take low credit and liquidity risks.
(The writer is fund manager, Fixed Income, Quantum Mutual Fund)