The RBI hiked rates across the board in its quarterly monetary policy review held on 20 April 2010, by raising the repo, reverse repo and cash reserve ratio (CRR) by 25 basis points each to 5.25%, 3.75% and 6.00% respectively. This was along expected lines, with certain sections of the market expecting rates to be hiked by as much as 50 basis points across the board. Equity markets cheered this by bouncing back and renewed interest was seen in rate sensitive stocks like banking, real estate and auto. On the fixed income side, the 10 year benchmark yield also subsided after rising to levels of 8.08% before the policy announcement.
Table 1: WPI and its Components in March 2010
|Manufacturing ex food products
|Source: MOSPI, iFAST Compilations
Meanwhile, industrial activity also continues to roar, with industrial production growing by 15.1% in February 2010, after registering a 16.7% growth in the previous month. The biggest boost in industrial production was seen from manufacturing, which has close to 80% weightage in the index of industrial production (IIP) and rose by 16.0% (y-o-y) during the month of February 2010. However, we expect industrial activity to moderate a bit in the coming months with the base effect wearing down, and with the central bank’s monetary tightening regime.
RBI moves to tighten liquidity within the system
The RBI absorbed about Rs.1,00,000 crores on a daily average basis under the liquidity adjustment facility (LAF) through reverse repo during the current financial year upto February 12, 2010, i.e., before the first increase in the CRR (which was announced in the January end monetary policy review) came into effect. At the end of January 2010, the RBI raised the CRR by 75 basis points, sucking out about Rs. 36,000 crores from the system.
During February 27- March 31, 2010, the average daily absorption of surplus liquidity declined to around Rs. 38,200 crores reflecting the increase in the CRR, year-end advance tax outflows and higher credit demand from the private sector. The recent 25 basis points hike in CRR by the RBI (effective from 24 April 2010) is expected to draw out another Rs. 12,500 crores from the banking system. Thus, liquidity has been gradually reducing within the banking system, but is still quite high considering RBI’s aggressive stance on combating inflation. Non-food credit growth has also recently picked up to 16.9% in March 2010, above RBI’s projection of 16.0% for the fiscal and recovering from its intra-year low of 10.3% in October 2009.
We expect credit growth to continue increasing with the strong pickup in economic and industrial activity and the proposed capex plans of India Inc. Money supply (M3) growth decelerated from over 20.0% at the beginning of the financial year to 16.4% in February 2010, before increasing to 16.8% by March 2010, slightly above the RBI’s projection of 16.5%. Refer to Chart 1 for M3 & Credit Growth and Reverse Repo Volumes.
1: Liquidity moderates while credit growth picks up
The central bank will also have to manage a large borrowing programme in FY11, although it is lower than what the markets had expected earlier. The total budgeted gross borrowing for the first half of FY11 (April – September 2010) is Rs. 2.87 lakh crores, which accounts for 63% of the borrowing for the entire fiscal (Rs. 4.57 lakh crores). This is lower than the borrowing in the first half of the previous fiscal year and also below market estimates of around 3 lakh crores. However, a front loaded (majority of borrowing in first half) borrowing programme will keep yields buoyant during the first half of this fiscal. On a net basis (after accounting for redemptions) the borrowing programme for FY11 is actually lower than that of the previous fiscal. However, the fresh issuance of government paper in FY11 will be 36% higher than the previous fiscal year. Refer to Table 2 for an overview of government’s borrowing programme.
Table 2: Government’s borrowing programme is front-loaded in FY11, but lower than estimates
|Source: RBI, Bloomberg, iFAST Compilations
RBI provides boost to the infrastructure sector
The central bank also announced some measures to boost flows to the infrastructure sector. Firstly, it has reduced the provision for sub-standard infrastructure loan accounts from 20% to 15%. This has been done with the view of meeting the increasing financing needs for infrastructure development within the country and encouraging banks to lend more to this sector.
Besides this, the RBI has also allowed banks to classify their holdings of non-SLR bonds (with a minimum residual maturity of seven years) issued by companies engaged in infrastructure activities under the held to maturity (HTM) category rather than mark to market (MTM) category as earlier. This should provide some valuation relief to banks and also may encourage more investment into bonds of infrastructure companies by banks.
As a result, infrastructure and realty stocks saw renewed buying interest and surged after the policy announcement.
RBI has been following a balancing act to manage inflation and at the same time not hurt economic growth too much. With the strong economic recovery and demand pressures building up on inflation, it is expected that the central bank will continue to hike rates and engage in further monetary tightening in a calibrated manner. With that view in mind we recommend debt investors to continue focusing on floating rate funds and short term funds (as suggested earlier). However, investors can look to re-enter or allocate more towards long-term and medium-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.