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RBI's big step after eight baby steps
May 6, 2011

The article details the highlights of the Monetary Policy statement for 2011-12 released by RBI on 3 May 2011. The article also details about the investments that investors can consider currently.

Author : Manjunath Gaddi

Untitled Document         

The RBI announced the monetary policy for 2011-12 on 3 May 2011. The key highlights of this policy are as below:

  • Repo rate increased by 50 basis points from 6.75% to 7.25% with immediate effect.
  • Reverse repo rate increased by 50 basis points from 5.75% to 6.25% with immediate effect.
  • Bank rate, Cash Reserve Ratio (CRR) and Statutory Liquidity ratio remains unchanged.
  • Repo rate will be the only independently varying policy rate and reverse repo would always be pegged at 100 basis points below the Repo rate.
  • Introduction of Marginal Standing Facility (MSF) to help the scheduled commercial banks to borrow up to 1% of their respective Net Time and Deposits liabilities (NTDL) at the rate of 100 basis points above the Repo rate.
  •  Increase in Savings Bank account deposit rate from 3.5% to 4.0% with immediate effect.
  • The money supply M3 growth for 2011-12 is expected to be 16%, while the deposit growth in banks is expected to be 17% and the non food credit growth is expected to be 19%.
  • The baseline GDP growth projection for 2011-12 is  8%.
  • The baseline WPI inflation projection for March 2012 is  6%.
  • The banks can now invest only up to 10% of their net worth as at 31 March of the previous financial year into liquid mutual funds.
  • The Current Account Deficit (CAD) is now expected to be around 2.5% of the GDP for 2010-11 in comparison to 2.8% in 2009-10.
  • The next mid-quarter review of Monetary Policy for 2011-12 will be on 16 June, 2011 and the First Quarter Review of Monetary Policy for 2011-12 is scheduled for 26 July, 2011.
Inflation and Industrial production growth roundup for 2011-12

The WPI inflation which was negative in June and July 2009 increased rapidly to 11% by April 2010 being above 7.48% in 2010. The average WPI inflation for 2010 is at 9.43% and for 2010-11 is 9.18%. The chart 1 shows the WPI inflation and the inflation of all the sub indices.

The Primary Articles inflation was high in March 2010 and has reduced over the year to about 13% as of March 2011.However, since January 2011, the manufacturing inflation has increased  rapidly from 3.75% in January 2011 to 6.21% in March 2011. The fuel and power sub index has been consistently over 10% in the last financial year.

The high level of food inflation during early 2010 was the main reason for the high WPI inflation, but due to good monsoons, the food inflation has reduced over the period. However, the manufacturing inflation has picked up since January 2011 which accounts for the rebound in inflation from past 2-3 months.

On the other hand, the industrial production growth is showing signs of induced strains by 2010 rate hikes. The chart 2 shows the volatility and the reducing trend of the industrial production. From a value close to 20% in April 2010, the industrial production growth has reduced to a growth between 4% and 2% in the recent month.

Chart 1:WPI Inflation for 2010-11

As seen from the graph, the industrial growth closely follows the growth in the manufacturing sub index. The mining sub index also follows the path of the manufacturing sub index. Only the electricity sub index has shown the resistance for decline, however, even the electricity sub index is not free from the volatility witnessed in the Industrial production growth.

Monetary Policy for 2011-12

Like the monetary policy for 2010-11, the monetary policy for 2011-12 highlights the fight against inflation as its key objective. To this effect, the Reserve Bank has finally taken the big step of increasing the repo rates and reverse repo by 50 basis points to 7.25% and 6.25% respectively. There is no change in either the bank rate or the Cash Reserve Ratio (CRR).  One basis point is equal to one hundredth of a percentage. The chart 3 shows the rate hikes by RBI in 2010.

In the past eight rate hikes since March 2010, the RBI had chosen baby step hikes of 25 basis points. These 25 basis points hikes were part of a calibrated approach to control inflation without impacting growth. However, all these rate hikes had little impact on the inflation. The inflation did show some moderation towards the end of 2010, but started increasing in 2011.
Chart 2: IIP and sub indices growth for 2010-11

The Reserve Bank has been fighting a battle with inflation much before inflation became a cause of concern in countries like China and Indonesia. The RBI had an initial target of 5.5% WPI inflation for March 2011 which was later enhanced to 7% in the third quarter monetary policy meet. This 7% target was further enhanced to 8% during the march mid quarter policy meet. The RBI now in this policy expects the inflation to be on the higher side in the first half of the financial year and later reduce to around 6% for March 2012.

There have been some structural changes in the policy. The repo rate is now the only independent policy rate. All the other rates would be linked to the repo rate. The reverse repo rate has now been linked to the repo rate and will be 100 basis points lower than the repo rate. Additionally, the RBI has started a new instrument to take care of the liquidity requirements of the banks. It is called as the Marginal Standing Facility (MSF) and would allow the banks to borrow overnight up to 1% of their NTDL at the rate of 100 basis points more than the repo rate.

However, it brings good news to people having a savings bank account. The RBI has increased the interest rate on savings account from 3.5% to 4.0% with immediate effect. This higher returns from saving account is lower than the returns from comparable investment avenues like the liquid funds or the ultra short term funds.

Chart 3: RBI policy rate hikes

The banks are the one of largest investors in liquid mutual funds, the investment from the banks alone constitute 17.07% of the total assets in liquid funds as at 31 March 2011. The liquid mutual funds in turn invest a part of their total liquid fund assets in instruments issued by the banks apart from money market instruments. This leads to circular flow of money and may pose risks to the financial system if the banks choose to redeem huge amount of money in a short period or during stress periods. To prevent such situations, the RBI has asked the banks to limit their investment in liquid schemes to a maximum 10% of their net worth as on March 31 of the previous year. Those banks with investments higher than the 10% limit have six months duration to bring their investments in the liquid funds to 10% or below.

Impact on the markets

The equity market has taken the hike as detrimental for the industry and economy and the SENSEX fell by 463 points or 2.4%.The main losers due to the policy hike were the Auto, Banking and Realty stock and indices. The BSE auto index fell the most by 3.7%, this was followed by BSE Bankex Index falling by 3.1% and the BSE Realty Index 2.9%. All the three sectors are interest rate sensitive. A 50 basis points hike as well as the 0.5% hike in the savings bank deposit rate will force the banks to increase its lending rates as well as hit their Net Interest Margin (NIM).

On the G- Sec market side, the 10 year and the 11 year G –secs were the most actively traded securities. The yield of all the three securities (7.80% GS 2021, 8.13% GS 2022 and 8.08% GS 2022) saw increase in the range of 6-8 basis points. The rate hikes by RBI and the continuing liquidity deficit situation will make the debt sector more attractive to domestic and international investors.

The banks are increasing their fixed deposit rates due to the liquidity deficit situation in the system and many mutual fund houses are launching Fixed Maturity Plans (FMPs) to help investors get better returns in comparison to fixed deposits.

Our recommendation to our investors

The 1 year Commercial Paper continues to be above 10% and 1 year Certificate of Deposit continues to be close to 10%. So, we reiterate our recommendations that we had given out between January 2011 and March 2011:

  • Investors who continue to hold on idle cash in their savings bank account can consider investing into Ultra Short term funds with dividend option, as the tight liquidity situation will yield more returns than the 4.0% on savings account. Our recommended funds in this category are DWS Ultra Short Term fund and Birla Sunlife Ultra Short Term Fund
  • Investors with 6 to 9 months time horizon can invest in short-term funds because the liquidity situation is expected to remain tight in the short term. Investors can consider investing into Reliance Short Term Fund and Templeton India Short Term Fund
  • Investors having a 3 to 24 months time horizon can invest in FMPs as it is a good time to lock-in yield at the current high levels. To invest in FMPs click here  

iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.


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