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Conservative RBI does it again...

Jul 26, 2011

That the RBI is not yet done with liquidity tightening was well anticipated. The first monetary policy for financial year 2011-12 was therefore expected to make borrowing costs dearer. But another 0.5% hike in repo and reverse repo rates today do not just make the rate steep. They feature India amongst the emerging economies where leverage is a huge deterrent for companies and individuals. This certainly is not all bad news in a scenario where excess debt has caused economies to go bankrupt. Or even the likes of the US to consider a debt default. However, the prohibitive interest rates will certainly ensure that the RBI's downward revisions of GDP and credit growth become a reality. In fact we will not be surprised if more such downward revisions follow.

The latest hikes put the repo and reverse repo rates at 8% and 7% respectively. This is while the 10 year G-Sec yield is at 8.2% and 5 year AAA bond yield is 9.6%. Thus, the gap between short and long term borrowing rates has narrowed considerably over the past 2 years. Between March 2010 and June 2011, the gap between the repo rate and the 10 year G-Sec yield has narrowed from 5% to 1% signifying the pace of monetary tightening.

Transmission of the central bank's monetary policy has also been strong lately, with banks raising their base lending rates by almost 2.25% in response to policy tightening. But, the 'fuel factor' in the economy is the point to watch. The recent hike in fuel prices may continue to impact inflation for some more time. So further tightening cannot be ruled out before the inflation numbers eventually subside.

Whether the rate hikes will impact corporate profitability?

The answer is a resounding yes!

We believe some slowdown is thus definitely on the cards. The RBI has revised the GDP growth estimates from 8.5% to 8%, while credit growth has been projected at 18% YoY instead of earlier estimates of 19% for FY12. Notwithstanding cautious attempt on the part of companies to keep their leverage low, the high borrowing costs could certainly impact growth and margins. Additional capex will have to be deferred and consumption could be hurt thereby affecting pricing power and profitability. Interest rate sensitive retail products such as cars, homes and consumer durables will be the first to take a hit. In fact, car sales have already borne an impact in the first quarter of FY12.

On the brighter side, we believe that the RBI's conservative stance will not just help contain inflation but also keep the Indian economy a class apart from growth obsessed - fiscally imprudent economies.

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