The Reserve Bank of India (RBI) stepped up its efforts to tame inflation by increasing both the repo rate and the Cash Reserve Ratio (CRR) rate by 50 basis points each (100 basis points = 1 percentage point). This latest move reflects the reversal in interest rate expectations in 2008. With domestic inflation under control and a slowdown in industrial production, markets were expecting monetary easing at the start of the year. However, a sharp rise in headline inflation numbers changed the interest rate environment dramatically.
The economy had witnessed a period of sustained high growth rate for the past few years and relatively lower inflation, helped by pre-emptive actions taken by RBI. It had withstood the rise in oil and commodity prices relatively well, helped by strong growth and the absence of a full passthrough of global energy prices. However, sustained domestic demand and rising imported inflation have led to a sharp rise in headline inflation numbers since March, leading to a slew of fiscal and monetary measures. This culminated in the multiyear high inflation numbers released two weeks ago, and RBI’s 50 basis-point hike in CRR and repo rates last week. Thus yields have moved up sharply across the curve.
On the other hand, strong capital outflows and concerns about the widening trade deficit have resulted in the rupee losing ground against major currencies. Despite the US dollar weakening in 2008, the rupee has weakened against the greenback. On the fiscal front, off-balance sheet items such as oil and fertiliser subsidies, the farm loan waiver and possible wage hikes due to Sixth Pay Commission recommendations, are raising concerns. Despite recent strong trends in advance tax payments, there are worries about possible revenue pressures due to an expected economic slowdown. In recent weeks,we have seen an uptick in nonfood credit growth—26.2% as of June 6.
While India’s external position remains strong, helped by large foreign exchange reserves and a relatively low external debt-to-GDP ratio, investors are worried about the impact of the increasing value of oil imports and FII outflows on the current account deficit. The RBI has clearly indicated that aggregate demand pressures have been on the higher side, despite monetary tightening, and seems focused on alleviating inflationary pressure. It has indicated that key economic drivers—investment and consumption—are strong, contributing to increased demand. In such a scenario, global oil prices and inflationary pressures are likely to determine domestic monetary policy.
In the near term, monetary policy is expected to retain a tightening bias. Any pause or change of direction will depend on inflation. We expect liquidity to remain tight, and, despite advance tax flows, the CRR hike, along with RBI intervention in forex markets, should remove excess liquidity from the system. The increased differential between repo/reverse repo rate is in line with the central bank’s stated policy of maintaining a wider band in uncertain times. Any unexpected increase in government’s borrowing programme leading to higher bond issuances will impact the demand-supply scenario. The average duration of our portfolios continues to be on the lower side, and we are focusing on accrual products. Investors should look to focus on funds such as shortterm floating rate funds, fixed maturity plans, and ultra short bond funds.
Courtesy: Franklin Templeton
