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AbhayRao HE MONETARY POLICY review and changes made by Reserve Bank of India (RBI) late last monthhavehadmixedreactionsfrommanyof the fixed income players. While some of the policy changes made and not made were expected, the hawkish stance now adopted by them has left many of the long-term investmentsinagreyarea,whereoneisnotwillingtomake an outright prediction on what may or may not happen. However,intheshortterm,thingsappeartobealotclearer with most market experts concurring with RBIs views and attempts to try and curb excess liquidation whilemaintainingenoughroomfortheGDPtogrow. Till now what RBI was basically following was a monetary expansion policy This was to try and avoid . recession setting into the country, and the policy was successful in doing so. However, the current price stabilityisoneof themajorconcernsthatthecurrentpolicy tries to address. Also, RBI has changed its inflation forecast from 5% which they had anticipated in July this year, to 6.5% and this will be a continuous cause of concern till the rate is under check. The new policy tries to maintain a dual role of keeping both recession and inflation in check. This would require them to maintain the balance between excessive liquidity and tightliquidity .Asof now,aroundRs3700crorecashwill be introduced into the system. This way liquidity will hopefully be curtailed to the point where inflation can bekeptatbay,yetleavingenoughroomfortheeconomy to grow explains YP Narang, head, Fixed Income (debt)Group,Unicon. In the new monetary policy changes announced, RBI hasleftitsrepo,reverserepoandCRRratesunchanged at 4.75%, 3.25% and 5%. This is pretty much what was expected this October so no surprises there. However, the overall tone of the policy has become hawkish and interest rates may begin to rise from as soon as the last quarterof theFY09-10. RBI has a pressing worry in terms of inflation; and earlierspeculationshavegivenwaytofact,asthewholesalepriceindex(WPI)projectionchangedto6.5%with an upside bias by March end 2010 from around 5.0% earlier. This is a 1.5% change in the projected inflation rate,injustaspanof 3months.Whilethereislittledoubt that the inflation is being fuelled by the supply side, RBI feelsthatthehouseholdsexpectedinflationratewillrise over the next three to twelve months. While the concerns over weak rural demand has left people fearing the worst for the overall GDP projections, RBI retained its GDP forecast of 6% with an upward bias for FY10. This has been done on expectations that investment activity in the country picking up pace, and the lagged impactof therecoveryinindustrialoutputontheservices sectors. RBI has also revised its non-food credit projection to 18% y-o-y in FY10 from 20% earlier, reflecting weak credit demand to date and availability of nonbankfundingsources. Therefore,themonetarypolicyoverallstancehasput keeping a vigil on inflation and stabilising inflation expectationsastheirprimaryobjective. This monetary policy also saw RBI taking its first steps towards an exit policy This was done, by terminat. ingthespecialliquidityfacilitiesaheadof theiroriginal March31,2010expiry .Theyhavealsohikedthestatutory liquidityratiobackto25%of netdemandandtimeliabilities from 24%, without changing the hold-to-maturity limitandloweredtheexportcreditrefinancelimit.Allof thisindicatesthatRBIisterminatingmanyof itsunconventionaltoolsandisnowswitchingmoretoconventional tightening tools. RBI also said it was worried about excess liquidity resulting in an unsustainable asset price build-up and they have thus increased the standard provisioning for loans to commercial real estate from 0.4% to 1.0%. It also enforced maintenance of the CRR on transactions in collateralised borrowing and lendingobligationsliabilities. We concur with RBIs growth assessment, but are more worried about inflation, as we expect. We feel that WPIinflationmaynear8%y-o-ybyMarch2010andaverage 6.8% in FY11. While growth this year should be subdued at 6.0% due to drought, we expect the virtuous spiral of rising asset prices, improving business and consumerconfidenceandeasieravailabilityof funding to boost GDP growth to 8.0% in FY11. We expect RBI to hiketheCRRaroundDecember,byacumulativetotalof 125bps by the fourth quarter of 2010, given rising inflationexpectationsandrisingnetcapitalinflows.Wealso expect the policy rate cycle to turn in the first quarter of 2010, with a cumulative total of 125bps of rate hikes in both the repo and reverse repo rates in 2010. RBI has already taken the first step towards a policy exit and a smoothandcalibratedpolicywithdrawalwillindeedbe much better than a steep rate hiking cycle later on concludesSonalVarma,EconomicResearch,Nomura. Aneesh Srivastava, chief investment officer, IDBI FortisLifeInsuranceCoLtdexplains,Inlightof higherinflation expectations and high liquidity in the system, the policy tone seems hawkish. However, RBI has maintained its stance on key rates given the fact that growth has yet not picked up to a satisfactory level. Increased SLRhasledtosofteningof yields.Asthebankingsystem issittingonasurplusSLR(27%SLR),postthispolicywe expecttheG-secyieldstoremainintherangeof range77.5%andthedeposit&lendingrateswillnotbeimpacted bythecurrentpolicy . Foranymonetarygoverningbodytoreacteffectively and accurately to curb inflation, interest levels and liquidityhavetobemaintainedenoughtopromotegrowth and not trip up while juggling all these points in the current world economic scenario is quite a task. This becomes especially difficult when growth rates are yet to reach a stable and acceptable level, the country has just facedapoormonsoon,whichnodoubtimpactsareagricultural growth adversely and hence GDP and the glob, al economy is still trying to shake off the past 2 years turmoil. Under the circumstances the current monetarypolicyhastriedtoimpactasmanyareasaspossible, especially those which require immediate attention. While the stance of RBI has had mixed reactions, one of thesectorswhichseem tohavegottentherawendof the dealisthebankingsector.InareportbyAnandRathiSecurities they point out, Contrary to widespread expectations of an increase in the HTM (held-to-maturity) limit of banks SLR investments, RBI considered it undesirable to raise it further. It also increased the provisioning required for standard advances to the commercialrealestatesector,from0.4%to1%,andstipulatedthattheNPAprovisioningcoverageratioagainst NPAs (non-performing loans) should be at least 70% by

Monday, November 2, 2009 New Delhi

PLAYING THE DEBT MARKET

With RBI trying to maintain a fine line between growth, inflation and liquidity in its latest monetary policy, the debt market undertone may offer investors safe opportunities

Key policy changes

Sep10.BanksgrossSLRholdingsarelikelytoriseto3233% by Mar 10, implying that ~30% of banks investment book would have to be marked-to-market. This is a potential negative for banks and government securities.WiththepresentNPAprovisioningcoveragelower than 70% for some banks, raising it to this level could squeezeFY11profitability . However,giventhefactthatWPI,(whichprovidesa lead for RBI policy action) is still sub 1% awaiting a revision in its benchmarks, RBI has taken a wait & watchstanceontheinterestrateincreasetocurbinflation. RBI has also increased its inflation target to 6.5% and has stated that its prime objective would be price stability Hence, a hawkish approach of RBI in the fu. ture cannot be ruled out. RBI may wait for the IIP numbernextmonthtogetaconfirmationonthesustenance of growth or otherwise and a revised WPI number to take any final decision. High liquidity conditions may forceRBItoincreaseCRRinthenearterm.Inanticipationof ahigherinflation&highliquidityinthesystem, the policy tone seems harsh. Special REPO Facilities have been withdrawn. Real Estate loan provisioning hasgoneup.NPAnormshavebeentightenedandprovisioning requirements are increased to keep the credit quality high. Collateralised borrowing and lending obligation (CBLO) borrowing would attract CRR hence the cost of borrowing would go up. Increased SLR has lead to softening of yields. As the banking systemissittingonasurplusSLR(27%SLR),postthispolicy we expect the G-sec yields to remain in the range of 7 -7.5%, while the deposit & lending rates would not be impactedbythecurrentpolicyfeltSrivastavaasfaras themonetarypolicyimpactgoes.

Indian banks' NPA coverage (%)

PNB Union Bank Bank of Baorda Yes Bank South Indian Bank HDFC Bank Bank of India 89.6 88.4 81.7 74.9 73.5 70.3 69.6 Axis Bank ICICI Bank SBI IndusInd Bank IDBI Bank Canara Bank 63.2 51.1 45.1 35.2 32.1 27.8

Source:AnandRathiResearch

RBI forecasts for FY10

% y-o-y GDP Actual (FY09) 6.7 RBI projection (FY10) Jul policy Oct policy 6.0 with upside bias around 5 6.0 with upside bias 6.5 with upside bias 18.0 18.0 17.0

Theres no secret to balance. You just have to feel the waves

--Frank Herbert

WPI inflation (period-end)

0.8

Non-food credit Aggregate deposit M3 money supply

17.3 19.8 18.6

20.0 19.0 18.0

Source:RBI,CEICandNomuraGlobalEconomics

Strategies
The current monetary policy changes clearly indicate thedirectioninwhichRBIisthinking.Withtheirkeyissuebeingtocurbinflationwhilemaintainingsomething for investors in terms if interest rate and keeping enough liquidity in the market, there are some good short-terminvestmentstrategiesonecanuse.If thelevel of inflationdoesincreaseforthenextoneyearasexpectedbysome,includingRBI,andthemonetarypolicydoes help bring it in check by 2010-11, then holding government securities which will try and maintain an interest rateof atleast2-4%aboveinflationmaynotbethatbadan idea,asfarasfixedincomeinvestmentsgo.Also,withthe yield increasing, the debt market instruments will drop in value and may provide investors a chance to play the interest-ratefuturesandderivativemarketsaswell. Maneesh Dangi, head of fixed income, Birla Sun Life Asset Management Company says, RBI still considers the trade off between supporting growth and reining in inflation expectations as a complex policy challenge, whereasthecurveispricinginaconvincingwithdrawal of monetary accommodation in the coming months. To be sure, RBIs endeavor will be to neutralise the rates quickly .Indiahashadanaverageof 6%policyrate(effectiveovernightfundingrate)inthelastdecade,andinthat context, the current policy setting looks extremely accommodative. But both the sovereign and OIS curves havealreadypricedinrapid-fireratehikesinthecoming months. Thus we believe that most of the curve points wouldtradeinarangeinthecomingmonths,withthe10yearbenchmarktradinginthe7%-7.60%range. Narang,whoalsofeelsthatthecurrentmonetarypolicy is very hawkish in nature, feels that if the liquidity levels are kept under check and the productivity levels arenotaffectedthenRBIwouldhaveachievedwhatthey setoutto.AlsowithRBIverykeenonmaintaininganinterest rate scenario that is a few percentage points over and above inflation, interest rates may continue to have an upward pressure based on inflation. Hence if one keep a look out for the level of inflation, they can have a fairly good idea as to which direction would interest rates move towards Narang concludes by saying Investors should not invest in long-term digit securities and should stick to short-term securities, so as to cut downontheinterestratefluctuationrisk.Also,withthe current liquidity levels being to the tune of Rs 1 lakh crore,thesystemshouldhavemorethanenoughmoney to maintain a growth rate and steady GDP despite the tightening RBI is hoping to achieve to curb inflation.

Impact