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Monetary Policy review: Pre-emptive move

Jul 25, 2006

Not letting the loopholes remain unplugged, the Reserve Bank of India (RBI) governor Dr. Y.V. Reddy, today chose to hike the benchmark short-term lending rates (repo and reverse repo) by 25 basis points each, in the first quarter review of the Monetary Policy 2006-07, despite all macro-economic indicators remaining stable. This hike succeeds the unscheduled hike of 25 basis points exercised after the Annual Monetary Policy in May.Key monetary measures

  • Bank rate kept unchanged at 6%.

  • Reverse repo rate and repo rate, each raised by 25 basis points to 6% and 7% respectively.

  • CRR (cash reserve ratio) kept unchanged at 5%.

Stance of the policy
The Annual Policy for FY07 had warranted the necessity to be able to meet the challenges posed by the evolving situation, given the unfolding of risks. It had also indicated that the balance of risks was tilted towards the global factors and that in a situation of generalised tightening of monetary policy, India cannot afford to stay out of step. While keeping in view the dominance of domestic factors as in the past, the review of the policy continues to assign more weight to global factors (read Fed rate and oil prices).

A key element of the stance is the focus on credit quality and financial market conditions to support export and investment demand in the economy for maintaining macroeconomic and financial stability. In the light of this, it is critical to note that with the demand of credit in the domestic economy remaining robust, the RBI deems the underlying inflationary pressures to be well contained and the inflationary expectations to be anchored for future economic growth (inflation target remaining 5% to 5.5%).

The stance also signals caution on the fact that the money supply, deposit and credit growth in the current fiscal are running well above the indicative projections.

Our view
The RBI has more than once in the recent past shown its maneuverability to global developments. Going forward, a continued vigilance on the global economy and the stance taken by central banks across the globe will enable it to align the domestic economy with the global trends. The bank's commitment to move towards capital account convertibility is a lead indicator of this. The RBI also retains a guarded stance in terms of GDP growth projections (7.5% to 8%) for FY07 as also the inflation targets. Despite the scintillating growth registered by banks in some high-risk asset classes, the RBI has been proactive in its regulatory measures (hiking the provisioning requirements on mortgage loan sand standard assets). The idea that rising interest rates will halt economic growth is also proven to be a misnomer. While the rate hikes may currently appear to be unwarranted, the central bank's "pre-emptive move" may certainly augur well (in terms of keeping away negative surprises) in the long term.

As far as the implication of the same on the stock market, typically, a rising interest rate scenario is considered unfavorable for equities because of the following reasons:

  1. On a relative basis, debt gains attractiveness. With the yield on the benchmark 10-year government paper hovering at over 8.28% (this is risk-free), for someone to invest in equities (a high risk asset class), the returns have to be much higher for that extra-risk.

  2. When interest rates goes up, it has a negative impact on the corporate sector. Even though the top-tier companies have a much stronger balance sheet (after a fund raising spree - equity and debt combined), when interest rates goes up, it is first reflected on the working capital side. This is likely to impact net profit margins. Since 1998 to 2005, net profit growth has outpaced operating profit owing to debt retirement and lower interest costs. But with interest rates inching up (along with higher depreciation charges because of capex), we believe that the growth in net profit will be in line or lower than operating profit growth. Of course, this is at the broader level and there can be exceptions.

Overall, taking risk-return equation in balance, we believe that equities can give returns of 15% to 18% over the next two to three years, which is reasonably higher than the risk-free rate of return (even after taking into account inflation). But the days of 50% to 100% returns on equities are over!

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