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How Dr. Urjit Patel's Appointment Will Impact Your Debt Portfolio - Outside View by PersonalFN
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How Dr. Urjit Patel's Appointment Will Impact Your Debt Portfolio
Aug 31, 2016

The decision of the Government to appoint Dr. Urjit Patel as India's 24th RBI governor dashed the hopes of those who thought the new governor would be an advocate of lower interest rates. Ever since it became clear that Dr Raghuram Rajan will say sayonara to RBI in September, an inflation dovish camp hoped to see a more harmonious governor at the helm of the Central Bank.

Now, it hasn't been just a coincident that India's 10-year sovereign benchmark bond witnessed a fall of close to 40 bps (basis points) in just last 2 months.

By promoting Dr. Patel, the then deputy governor, as the successor of Dr. Rajan, the Government hinted at continuity in the policy stance. This seems to have caused some discomfort to those who didn't anticipate the new governor to be from Dr. Rajan's camp. It wouldn't be an exaggeration to call Dr Patel his right hand. Dr. Urjit Patel is a man who played a lion's role in institutionalising a whole host of changes that took place at RBI under the governorship of Dr. Rajan. No wonder then bond yields have started hardening since the news of Dr. Patel's selection broke.

On this backdrop, many of you must be anxious to know how the changing environment will affect your portfolio of debt funds. Let's assess the impact.

Before moving to bond yields, let's first understand where the Indian economy stands at the time when Dr. Patel is taking charge of affairs at the Central Bank. At the moment, India undoubtedly remains one of the fastest growing economies in the world. Having said that, the country has been facing some of the common problems, along with other emerging market economies.

The problems India's economy faces today are....

  • India has been struggling to rein in retail inflation, which is primarily driven by rising food prices.
  • Indian banking system has been reeling under the pressure of rising Non-Performing Assets (NPAs). The bad asset quality of banks has not only been affecting the credit flow in the system but impeding the process of monetary policy transmission as well.
  • The performance of India's manufacturing sector has been lacklustre, and export numbers have been flat as well.
  • Dampened demand and excess capacities in many sectors have been delaying the recovery in the private capex cycle. Corporates are shying away from making fresh investments for three reasons: stretched balance sheets, high-interest rates, and uncertain outlook. As a result, the job market is also negatively impacted due to a cautious approach -- the absence of aggressive growth plans.
  • Fortunately, narrowing current account deficit and stable fiscal deficit are the positives. Relative outperformance of the Indian Rupee in recent times has been a function of these two factors. Moreover, active forex management by the RBI also provided assistance in maintaining the competence of Indian currency.
Spike in Inflation....

KYG (Know your Governor):

Dr. Patel, a PhD from Yale University, has served in various capacities and has assumed prestigious positions in the past. Like Dr. Rajan, he too has IMF roots.

For his recent work in institutionalising changes and especially in the monetary framework has earned him great respect. Some have already started calling him an "inflation hawk". But his contributions go much beyond his tough stance on inflation.

Besides serving as a key member of various central and state government committees, Dr Patel has unparalleled corporate experience. He has an in-depth understanding of several sectors such as finance and energy to name a few. His extensive experience of working with the Government departments and with important ministries would enable him to address many complicated problems such as the conundrum of NPA. Moreover, he stands a high chance of convincing the Government on various fronts wherever a swift Government action is required. Addressing supply constraints in some sectors is one example.

India's macroeconomy and monetary policy outlook:

The appointment of Dr. Patel has sent a strong message to the global investors that India is serious about curbing inflation and maintaining fiscal discipline. The Government has already guided that the inflation target for the next 5 years would be 4.0% with a 2% margin of error on either sides. This is consistent with the RBI's assessment of inflation India needs to achieve for growing at a sustained pace. Although the goal of RBI to achieve 5.0% inflation by March 2017 appears difficult, especially after considering the spike experienced in the recent months, the central bank seems confident about meeting it. To be able to achieve that, food inflation has to fall. A good monsoon has lit up hopes for moderation in price hikes of food articles. Higher Minimum Support Prices (MSPs) for pulses, higher sowing in Kharif season and improved availability of water resources bode well for the agricultural sector. While the impact of the implementation of 7th pay commission is unknown so far, unutilized capacities in the corporate sector may absorb the higher demand for some more time before showing inflationary pressures. As per the assessment of RBI, about 55.0% of Consumer Price Index (CPI) will remain unaffected by the implementation of GST (which is unlikely to impact this fiscal). The GST is expected to be inflationary at least in initial phases. The Revenue Neutral Rate (RNR) has not been lannounced. A higher rate will be inflationary.

On the fiscal consolidation front as well, the Government remains committed to the fiscal deficit target of 3.5% for FY 2016-17. The Government has been rationalising the subsidies which would assist in achieving the fiscal deficit targets.

Q1 FY 2016-17 results suggest that many banks have been experiencing mild improvement on the NPA front. It is expected that, as and when the economy picks up and credit demand rises, banks will pass on the benefits of rate cuts they enjoyed since January 2015. Most of the banks have passed on only about 55%-60% gains of rate cuts to their borrowers.

Monetary Policy Committee to take decisions...

After appointing the governor, the Government may select its 3 representatives on monetary policy committee soon. Although the Governor will have a deciding vote in case of a tie, a decision on monetary policy would be taken by 6 people (including him) after reviewing the economic situation. It is expected that the monetary policy committee will end all ambiguities associated with the decision on policy rates and bring in more transparency.

The impact on bond markets...

For any bond market to attract investors, the credibility of the central bank and that of the Government is an absolute prerequisite. With the appointment of Dr. Patel, a strong message has gone far and wide. Therefore, except for knee-jerk reactions related to particular events that lose relevance over a short time, bond markets are likely to remain stable. At a time when negative bond yields have become a commonplace, Indian bond markets would stay relevant.

What do independent rating agencies feel about India's prospects?

Recently, speaking to BTVI, Marie Diron, Senior Vice-President, Moody's expressed confidence that India will have stable and predictable monetary policy environment. The Hindu Business Line, dated August 23, 2016 published the excerpts of her interview that reveled, "The new Governor will work with the RBI as a whole and with the Monetary Policy Committee (MPC). And all of that should help in enhancing the transparency and predictability of monetary policy decision, which is an important element to ensure efficiency. So in general, we do not see any significant change in the way monetary policy is formulated in the next few years."

Answering a question on the role RBI might play in controlling inflation under the new governor, she expressed, "From a sovereign credit profile perspective, we look at two sets of policies from the RBI and we expect continuity on those. One is monetary policy and delivery of moderate inflation. There are potentially upside risks to inflation in countries like India where half the (CPI) basket consists of food prices that are little predictable. But overall we expect moderate inflation to prevail in the next few years through a particular commitment by the RBI on delivering its target. The second set of policies is cleaning up the banks' balance sheet, which has started. But it will continue for some time before we see revival in investment and bank lending. But we do expect further progress on that area, too."

Moody's affirmed India's sovereign rating Baa3 last year, however, changed the outlook to "positive" from "stable".

In a nutshell:

With the establishment of the monetary policy committee, the policy decision will be institutionalised. Appointment of Dr. Patel, a man who has closely watched and has participated into the transformation of India's policy framework would aid in maintaining the continuity in the policies. In short, nothing changes substantially for bond markets. The war against inflation will continue.

Here's the investment strategy...

Look at your time horizon before investing in any debt fund. Most of the rally has already been captured at the longer end, although some steam remains on the expectation of an accommodative monetary policy stance by RBI. Therefore, don't go overboard while investing at the longer end; refrain from investing more than 20% of your allocation in debt funds. We suggest, consider dynamic bond (as they are enabled by their investment mandate to take positions across maturity profile of debt papers) while taking exposure at the longer end, provided you have an investment horizon of at least 3 years.

In case you have a time horizon of less than a year, stay away from funds with longer maturities. If you have a short-term investment horizon of 3 to 6 months, you could consider investing in ultra-short term funds (also known as liquid plus funds). And if you have an extreme short-term time horizon (of less than 3 months) you would be better-off investing in liquid funds.

Don't forget that investing in debt funds is not risk-free. Hence consider the 5-facets while investing in debt funds.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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