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RBI Cracks the Whip and Hikes Rates; S&P Upgrades the Ratings Outlook of India to Stable
March 24, 2010

The RBI made a surprise move by hiking the reverse repo and repo rate by 25 basis points on 19 March 2010, ahead of the quarterly monetary policy review scheduled for 20 April 2010. At around the same time, the credit ratings major Standard & Poor (S&P) raised the outlook on India's sovereign debt rating to stable from negative. We analyse the impact of these two announcements on the markets and what actions investors should take in their mutual fund portfolios

Author : Dhruva Raj Chatterji

Untitled Document
Chart 1: Wholesale price inflation nears double digit territory

Chart 2: Fall in liquidity within the banking system

Chart 3: India’s yearly fiscal deficit (as a % of GDP)

Chart 4: With interest rates hardening, the assets of floating rate and short-term funds balloon up

Key Points

  • RBI hikes the reverse repo and repo rate by 0.25% on 19 March 2010. Further rate hikes can be expected in the 20 April 2010 quarterly monetary policy review
  • The main cause behind the rate hikes is the spiralling inflation which clocked in at 9.89% for the month of February 2010 and is even expected to break into double digits in the next month
  • Other than the food inflation, concerns are now building up on inflation spreading to other parts of the economy as manufacturing and fuel inflation picks up
  • Other central banks in the Asia – Pacific countries of Australia, China, Malaysia and Vietnam have also engaged in monetary tightening
  • Ratings major S&P upgrades India’s sovereign credit rating outlook to ‘stable’ from ‘negative’ earlier, after the fiscal consolidation plan was laid out in the Union Budget in February
  • The government plans to cut down the fiscal deficit from 6.7% (of GDP) in FY 2009-10 to 4.1% (of GDP) in FY 2012-13
  • With bond yields expected to harden further we recommend more allocation to products that are less susceptible to interest rate risk like Floating Rate Funds and Short Term funds

Spiralling inflation prompts RBI to hike rates

In a surprise move, the Reserve Bank of India (RBI) has hiked the reverse repo and repo rate by 25 basis points (0.25%) each on 19 March 2010, ahead of the monetary policy review scheduled for 20 April 2010. Basically, the Repo rate is the rate at which banks borrow from RBI; it was increased to 5% from 4.75% earlier. On the other hand, the Reverse Repo rate is the rate at which RBI borrows from banks which was increased to 3.5% from the previous 3.25%. An increase in repo and reverse repo rates makes cost of borrowing more expensive. During the financial crisis, the RBI had reduced the repo rate by 425 basis points, reverse repo by 275 basis points and cash reserve ratio (CRR) by 400 basis points. However in the January 2010 monetary policy review, the RBI had hiked the CRR by 75 basis points to 5.75%, thus initiating its monetary tightening regime.

Even though the markets had largely factored in a 25 – 50 bps hike, the central bank surprised markets by doing it ahead of the actual policy review meet. This indicates that the RBI is taking all possible steps to control the spiralling inflation problem, which is slightly away from the double digit mark, clocking in at 9.89% during the month of February 2010 . Wholesale price inflation (WPI) had earlier touched a record high of 12.82% during the month of August 2008. The main cause of surging inflation is food inflation, which came in at 17.8% on year-on-year (y-o-y) basis for the month of February albeit dropping marginally over the previous month. However, food inflation is expected to subside in the coming months, due to a good rabi (winter) crop and with the base effect wearing down from June 2010 onwards. Presently, food articles have more than 15% weightage in the WPI (which is the headline inflation rate in India). However, the weightage of food articles in Consumer Price Inflation (CPI) index is much higher at close to 46% (in the CPI – Industrial Workers index), as a result of which consumer inflation is much more bloated at 16.22% for the month of January 2010. Refer to Chart 1 for movement of wholesale price inflation and consumer price inflation (industrial workers).

However, the biggest worry which even the RBI acknowledges is that inflation is starting to spread to other parts of the economy, with fuel and manufacturing inflation picking up in recent months. Fuel inflation, which has close to 14% weightage in the WPI rose 10.2% (y-o-y) during the month of February 2010, while manufacturing inflation (which has close to 64% weightage in the WPI) rose to 7.4% (y-o-y) during the same month. The hike in fuel prices announced during the Union Budget FY 2010-11 in February, along with the hike in excise duty will put further pressure on fuel and manufacturing inflation during the month of March 2010. Refer to the Table 1 below for breakup of February 2010 WPI inflation.

Table 1: Breakup of Wholesale price inflation in February 2010
WPI and its Components in February 2010
  Weightage in
WPI index
YoY growth
in Feb 10
Overall 100.0% 9.9%
Primary Articles 22.0% 15.5%
Food articles 15.4% 17.8%
Non-Food Articles 6.6% 13.3%
Fuel 14.2% 10.2%
Manufacturing 63.8% 7.4%
Food products 11.5% 20.4%
Manufacturing ex food products 52.3% 4.2%
Source: MOSPI, iFAST Compilations


Outlook on inflation and rates

Even though inflation is expected to touch double digits in the month of March, it is unlikely to revisit the record high levels of 12.82% seen in August 2008 in the coming two-three months. However with the sharp pick up in industrial activity, improving economic fundamentals and continuing pressure on inflation, it is likely that RBI may hike both the reverse repo and repo rates by yet another 25 -50 basis points in the 20 April 2010 monetary policy review. A further hike in the CRR can also be expected to keep liquidity under a tight leash. However the indicators for liquidity (M3 growth and reverse repo volumes) imply that monetary tightening measures have worked, and liquidity has dried up a bit within the system. Refer to Chart 2 for M3 growth rates and Reverse Repo volumes.

Other Asia – Pacific Central Banks Also Initiate Monetary Tightening

Central banks within the Asia – Pacific region have been among the first to engage in monetary tightening, as growth picks up within the region and inflationary fears raises concerns. Other than India, China’s central bank raised the reserve requirement ratio by 0.5%  on 18 January 2010 and then by another 0.5% on 25 February 2010. Raising the reserve requirement ratio implies that banks have to park more money with the central bank, thus sucking out excess liquidity from the system. Chinese consumer price inflation rose to a 16 month high of 2.7% in the month of February, and the central bank is expected to raise interest rates soon.

Australia’s central bank also raised its key interest rate by 25 basis points to 4% in early March 2010, making it the fourth time that the central bank has raised rates since October 2009. Australia’s GDP growth accelerated to its fastest pace of 0.9% in the last quarter of year 2009, bringing the full year growth in 2009 to 2.7%. Meanwhile, Malaysia’s central bank also raised its key interest rate by 25 basis points to 2.25% in the beginning of March citing that domestic recovery is firmly established. After three quarters of negative growth, Malaysia’s economy turned around in the fourth quarter of 2009 to post a higher-than-expected growth of 4.5% (y-o-y). Earlier, Vietnam had also increased its benchmark interest rate to 8% from the start of December 2009 and devalued its currency (the Dong) by 5% to help rein in inflation and lending. Besides this, the central banks of some other Asian countries like Indonesia, Taiwan, and Thailand and economic growth picks up and inflation concerns also rise.

S&P upgrades India’s Sovereign Credit rating outlook to stable

Global ratings major S&P upgraded India’s sovereign credit rating outlook to ‘stable’ from ‘negative’ while maintaining the rating at BBB- (the lowest within the investment grade).  S&P had earlier downgraded the rating outlook to negative in the month of February 2009 due to growing concerns of weak government finances and rising fiscal deficit. Refer to Table 2 for India’s Sovereign Credit Ratings from three major ratings agencies since the year 2001. However in the Union Budget FY 2010-11, the finance minister pledged to undertake fiscal consolidation reminiscent  of the fiscal responsibility budget management (FRBM) act laid out a few years ago. The FRBM act was enacted by Parliament in 2003 to bring in fiscal discipline by reducing the fiscal deficit to 3% by FY 2008-09. The present fiscal consolidation plan entails a reduction of the fiscal deficit to 5.5% in FY 2010-11 from 6.7% of GDP in FY 2009-10, and then to 4.8% in FY 2011-12 and to 4.1% in FY 2012-13. Refer to Chart 3 for India’s fiscal deficit figures. As a result of this plan, S&P has upgraded its outlook but has highlighted that a ratings upgrade will only be considered if the following conditions are met:

  • A reduction in subsidies on food, fertilizer and fuel
  • Central and state government commitment to the fiscal consolidation plan
  •  Early implementation of the Goods and Services Tax (GST)


Table 2: India’s Sovereign Credit Ratings from year 2001 to year 2010
India's Sovereign Credit Rating from 2001 to 2010
Year Moody's S&P Fitch
  Rating Outlook Rating Outlook Rating Outlook
2001 Ba2 Speculative BB Speculative    
2002 BBa2 Stable BB Negative    
2003 Ba1 Stable BB Negative    
2004 Baa3 Stable BB Stable    
2005 Baa3 Stable BB+ Stable BB+ Stable
2006 Baa3 Stable BB+ Positive BBB- Stable
2007 Baa3 Stable BBB- Stable BBB- Stable
2008 Baa3 Stable BBB- Stable BBB- Stable
2009 Baa3 Stable BBB- Negative BBB- Stable
2010 (as of March) Baa3 Stable BBB- Stable BBB- Stable
Source: Standard Chartered, Ministry of Finance, iFAST Compilations

What should a mutual fund investor do?

Since the RBI is expected to continue to engage in monetary tightening and raise rates in the coming months, interest rate sensitive sectors like banks, real estate and automobiles may be adversely impacted in the short term. Thus investors should look to avoid these sectoral funds or those funds which maintain high exposure to these rate sensitive sectors. Banking stocks presently have the highest exposure in portfolios of equity mutual funds in India; but their exposure has been gradually reduced. As per data from capital market regulator SEBI, the exposure of banking stocks in equity assets of mutual funds in India has reduced from 14.38% in September 2009 to 12.99% in December 2009.

On the debt side, with bond yields expected to harden further we recommend investors to avoid gilt and other long term income funds presently, since they are more sensitive to interest rate risk. Debt investors should allocate more to shorter tenure products that are less sensitive to interest rate movements. These include floating rate funds and short-term funds. The assets of floating rate funds in India have ballooned by a phenomenal 650% between December 2008 and February 2010, while the assets of short-term funds in India have risen by close to 230% over the same period. Refer to Chart 4 for trend of assets managed by floating rate funds and short term funds in India. However, investors can look to re-enter or allocate more towards long-term bond funds once the 10 year benchmark yield reaches levels of 8.3% to 8.4%, where we feel that bond yields may peak out.

related articles:

RBI hikes CRR by 0.75%, beats market expectations
India's Banking Sector - Dealing with Inflation and interest rate hike fears
China's Faster-than-expected Recovery Leads to an Unexpected Rate Hike!
India's Inflation Accelerates to 7.31% in December

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