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Monetary Policy Meeting : key measures - Outside View by Arvind Chari
 
 
Monetary Policy Meeting : key measures

  • Repo rate unchanged at 8%

  • Liquidity to be provided through Repo; term Repos and daily one-day operations to smooth liquidity - which will effectively keep call rates anchored to 8%. Reduced Export Re-finance facility

  • SLR unchanged at 22%

  • HTM (held to maturity) on SLR bonds to be reduced from 24% to 22% between January to September 2015 - Provides clarity and gives enough time for bankers to adjust their balance sheets without any undue market disruption

  • Will allow SLR of upto 5% to be treated as liquid assets under the Liquidity Coverage Ratio (LCR) rules of Basel III. This is a pragmatic move and will lower the burden on banks to meet LCR norms.
Policy Stance and Outlook

The RBI by slowly moving to a 'soft' inflation targeting approach has effectively made policy moves very predictable. The CPI inflation targets of 8% by January 2015 and 6% by January 2016 is etched in market memory and as we move towards the target dates even markets expectations are more of less falling in line.

RBI believes that the 6% target still has significant upside risks and its own Model forecast puts CPI at 7% by March 2016. But they still believe that they are on course to achieving the target and hence see no necessity of rate hikes. At the same time, they done see any immediate scope of rate cuts either.

Low Oil prices and a stable exchange rate is definitely helping the inflation outcome. A better than initially expected monsoon coupled with lower MSP increases should keep food prices under lid. Lower wealth effect from gold and land prices and lower wage and income growth should continue to add disinflation into the economy. And thus moving CPI towards RBIs targets.

Based on that we believe that rate cuts are in the offing in sometime mid 2015. But with a caveat that Dr. Rajan is not one who would fall for tokenism.

He will risk his and RBIs credibility only if he is able to see rate cuts of 50-100 bps over time. Which means CPI sustaining at 6% and thereabouts. Only then will he begin the process of rate easing.

A sign to look for RBIs comfort would be to track the way they manage liquidity. Much before any rate cuts, the RBI would first start easing liquidity. In a rate easing cycle, the transmission would be fastest only when liquidity is also in a surplus mode. In the previous easing cycle of 2013, although RBI cut rates but lending rates didn't budge at all. And that was due to the fact that system liquidity was negative.

I feel that as the RBI gets comforted on the inflation trajectory, it would start easing liquidity to put in a surplus mode. And that would be the signal that rate cuts are in the offing. So watch for that.

Another point which gets discussed around monetary policy is the real rates. (Real Rate is nominal interest rate minus inflation). There is no defined 'Real Rate' and the central banks would tend to react only when Real rates go too negative (hurting the saver) or too positive (hurting the borrower). Generally a 1-2% positive Real Rate is taken as thumb rule during normal economic conditions.

Chart I & II: Real Interest for the borrower and Real Interest rates for the saver
(Source : Bloomberg; RBI. Real Repo rate for Industry = Repo Rate minus Core WPI; Real Repo rate with CPI = Repo rate minus headline CPI (Using CPI IW before 2012)

Take a look at the charts above

Real interest rates when taken as headline CPI (Chart II) is still low and thus we need maybe another year of positive real interest rates to incentivize the saver and boost deposit growth. See the period between 2010-2012; as negative real interest rates drove money out of financial savings (Deposits) into physical assets (Gold and property)

But when looked at from an industry's perspective; it requires real interest rates at zero or negative for them to build capacity. Taking Core WPI as measure of industry pricing power; Real Repo for industry is significantly positive.. and has been for the last 2 year (maybe ) explaining the slowdown.

As for now we believe that the RBI is clearly in the side of the saver and hence would keep nominal interest rates high enough. But at some time in the future, as India seeks to re-invest for future growth; the RBI would have to make some way out for the borrower. Watch out for that trade-off.

Market view

Given that Repo rate is on hold for some time; long bond yields should remain range bound; But as we have maintained earlier; there should be a bias towards owning longer maturity bonds in order to benefit out of the rate easing expected next year. Another factor in favor of that is also that fiscal supplies will be lesser in the second half and demand for bonds remain buoyant.

The same would apply for investor in fixed deposits. Elongate the maturity of your fixed deposit.

For investors in liquid fund, we expect RBI to hold 8% call rate as of now and hence spread assets at 50-75 bps higher is what one should expect an good credit quality portfolio to yield over the next few months.

Arvind Chari is Head Fixed Income & Alternatives at Quantum Advisors Pvt Ltd and advises two India dedicated off-shore India fixed income funds. Arvind was previously the fund manager for the Quantum Liquid Fund and the Quantum Equity Fund of Funds at Quantum Asset Management Company Pvt Ltd.

Disclaimer:
The views expressed in the Article are the personal views of the author, Arvind Chari and not views of Quantum Advisors Private Limited (QAS). QAS may or may not have the same view and does not endorse this view.

 

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