Friday 17 June 2011

RBI Monetary Policy - Mid-Quarter Review of June 2011-VRK100-17062011

RBI Monetary Policy
Mid-Quarter Review of June 2011


Rama Krishna Vadlamudi, HYDERABAD June 17, 2011

As expected, the Reserve Bank of India has raised its benchmark Repo rate (under its Liquidity Adjustment Facility or LAF) by 25 basis points to 7.50 per cent when it announced the mid-quarter monetary policy on June 16, 2011. The new rate is with immediate effect. The Reverse Repo rate under LAF and the interest rate under Marginal Standing Facility are linked to Repo rate. As such, both the Reverse Repo rate and Marginal Standing Facility rate stand increased to 6.50 per cent (one per cent below Repo rate) and 8.50 per cent (one per cent above Repo rate) respectively with immediate effect.

Since the beginning of year 2010, RBI has been increasing the interest rates continuously. The latest Repo rate hike is tenth increase since March 2010 when RBI increased Repo rate from 4.75 per cent to 5.00 per cent – the cumulative increase in Repo rate amounts to 275 basis points (or 2.75 per cent) in the last 15 months.

Rationale

What is the rationale behind RBI’s latest increase in rates?

 Inflation rate of 9.1 per cent (provisional figure) remains at highly uncomfortable levels due mainly to high commodity prices

 Non-food manufactured goods prices have gone up in May 2011 in addition to higher inflation of food articles

 Manufacturers are passing on the increase in wage cost and service cost to consumers as is evident in the inflation indices

 Private consumption is at higher levels even though there is some deceleration in some sectors, like, automobiles

Impact

The present rate hike from RBI is on the expected lines. The stock market as well as the bond market has weakened considerably well before the announcement of the RBI’s rate hike. In its Annual Policy announced on May 3rd this year, RBI raised the Repo rate by 50 basis points in one go. After the Annual Policy announcement, commercial banks were quick to increase their lending rates suggesting strong monetary policy transmission, which indicates the ability of the RBI to pass on its policy initiatives to the broader economy.

On June 16, 2011, the benchmark Sensex closed at 17,986 down 0.81 per cent over the previous day’s close and the Nifty was down at 5,397. The downtrend is likely to continue till the next policy announcement by RBI. One can expect Sensex to drift down another 10 per cent from the current 18,000-level.

The bond market too had been reacting negatively in the last six weeks or so to the expected increase in RBI rate hikes. The benchmark 7.80 per cent 10-year Government of India security maturing in 2021 was showing signs of weakness till the policy announcement yesterday. But, after the rate hike announcement mid-day, the bond prices have gone up and the benchmark paper’s yield declined to 8.30 per cent from 8.38 per cent the previous day (bond prices move in opposite direction to bond yields). The future for Government bond prices looks weak now.

Commercial banks have been enjoying good net interest margins. As such, they may absorb some of the present rate hike themselves while some portion of the burden will be passed on to borrowers. Banks may increase their deposit rates also depending on the credit offtake. Overall, borrowers can expect rate increases in home loans, car loans, coporate loans, etc. This in turn will adversely affect domestic consumption.

Outlook

It is not clear whether the RBI’s actions in the last 15 to 18 months have been able to contain inflationary expectations even as GDP growth rate has moderated to 7.8 per cent in the January-March 2011 quarter from 9.4 per cent in January-March 2010 quarter. There is visible slowdown in manufacturing as indicated in the Industrial Index of Production (IIP). In the month of April 2011, IIP is at a sober level of 6.3 per cent. However, the apprehensions regarding the effectiveness of monetary policy in containing growth-induced inflation remain unanswered at this point of time.

Diesel price may be increased by the Government as the fiscal deficit may go out of control this year due to higher cost of imported crude oil. The subsidy burden of diesel, LPG and kerosene is too heavy for the Government. The liquidity situation seems to be comfortable now. Credit growth is around 21 per cent year-on-year above the RBI’s indicative projection of 19 per cent. The monsoon is most likely to be normal this year providing some hope on the food inflation front.

With stock markets languishing in sideways to downward trend, it remains to be seen whether the Government will be able to go ahead with its disinvestment programme. If it fails to raise additional money through disinvestment, its hold on the fiscal situation will deteriorate leading to higher fiscal deficit. Higher fiscal deficit may translate into higher interest rates in future. If the Government increases diesel prices, it may further accentuate inflationary expectations in the economy.

The financial markets have been expecting another rate hike of a minimum of 50 – 75 basis points before the end of this fiscal year. However, what needs to be emphasized is that RBI will be keenly watching the important data, like, inflation, GDP growth, tax collections, disinvestment of public sector companies, oil prices, global cues, and others, before making further moves on its fight against inflation monster.

In the last 15 months, RBI has been increasing interest rates as per market expectations as inflationary pressures have been building up in the economy. But the same cannot be said for the future RBI’s moves on interest rates. Next time, we need to expect the unexpected from RBI. Even though many experts and analysts have been expecting 50 to 75 basis points increase, we need to keep our fingers crossed and keep a close eye on data.

Repo rate: The overnight rate at which banks borrow money from RBI by pledging Government securities with RBI

Reverse Repo rate: The overnight rate given by RBI to banks when the latter keep their surplus funds with RBI (one per cent below Repo rate)

Marginal Standing Facility (MSF): Banks can borrow overnight from the RBI’s MSF up to one per cent of their respective net demand and time liabilities or NDTL. The rate of interest on amounts accessed from this facility will be 100 basis points (one per cent) above the repo rate.

LAF – RBI’s Liquidity Adjustment Facility

RBI – Reserve Bank of India,

LPG – Liquefied Petroleum Gas

GDP – Gross Domestic Product or national income

IIP – Index of Industrial Production

Disclaimer: The views of the author are personal.

The author writes copiously on financial markets – equities, bonds, currencies, taxes, Indian economy, etc. You can read these articles on:

www.scribd.com/vrk100

or

www.ramakrishnavadlamudi.blogspot.com





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Tuesday 14 June 2011

Market Outlook-VRK100-14062011

Market Outlook

In a state of flux


Rama Krishna Vadlamudi, HYDERABAD June 14, 2011


With Sensex hovering around 18,250 and Nifty well below 5,500 at the end of June 13, 2011, the Indian stock market looks to be in a lackluster phase. Investors seem to be worried about inflationary concerns, GDP growth deceleration, lack of governance, policy paralysis and political controversies surrounding anti-corruption stirs. However, investors are looking to a good monsoon, some solution to the anti-corruption agitations and some policy reforms. It remains to be seen whether investors’ expectations will be met. More rate hikes are expected from Reserve Bank of India in this fiscal year.

Inflation

Food inflation proves to be a nemesis for the Government with the latest figures showing a jump in food inflation to 9.01 per cent for the week ended May 28, 2011 compared to previous week’s 8.55 per cent. There is a big mismatch between supply of and demand for food items. Adding to the supply constraints is the rise in demand for food fuelled by rising income levels for the middle income groups in the urban as well as rural areas. Government seems to be having no right solution to control the food inflation in the immediate future. The Government seems to have passed on the buck to the RBI.

RBI rate hikes

Reserve Bank of India has been increasing policy interest rates for the past one year in order to contain inflationary expectations in the economy. It is expected to increase the benchmark repo rate by another 25 basis points or 0.25 per cent when it announces the mid-quarter review of its monetary policy on June 16th. The rate hikes are expected to continue for another two to three quarters. The markets have been bracing themselves for a further rate hike of 50-75 basis points in policy rates in this fiscal year. The banks may absorb some of the rate hikes themselves by compromising on their net interest margins and may pass on only a portion of the rate hikes to borrowers. The banks’ margins at present are at elevated levels giving them some cushion to absorb the rate hikes.

India’s GDP Growth

In the last four quarters, India’s GDP growth has come down substantially. After touching a high growth of 9.40 per cent (year-on-year) in the January-March 2010 quarter, the growth rate has come down progressively to 7.80 per cent in the January-March 2011 quarter. But the consumption theme seems to be in good shape despite the visible signs of a slowdown in the economy.

FII inflows

After pumping in $ 17.5 billion in 2009 and $ 29.4 billion in Indian equity markets, foreign institutional investors (FIIs) have slowed down their investments in Indian stock market during this calendar year. At $ 85 million of net inflows in this calendar year, their investments have been almost negligible. However, in the first two weeks of this month, they have put in $ 467 million or Rs 2,103 crore in the Indian equity market. The FII appetite for Indian stocks will depend on several global factors, including inflationary concerns in India. The US Federal Reserve (Fed) has been buying bonds worth $ 600 billion. The buying programme, known as Quantitative Easing 2 or QE 2, is coming to an end on June 30th. It is not yet clear whether the Fed will continue or stop its easy money policy after June 30th. If the Fed continues with another round of bond buying or QE 3, this easy money from the US will chase commodities and may push up commodities’ prices which may be negative for India in general.

Commodities

In the last one month, most of the commodities have come off their inflated levels. Silver has lost 30 per cent from record levels of close to $ 50 (per ounce) levels to $ 35.5 now. Crude oil on Nymex has come down to $ 97 (per barrel) levels with Brent crude hovering around $ 119. But gold prices remain steady at around $ 1,530 per ounce. Gold may continue its dream run for some more time as Europe is going deeper and deeper into a bigger mess following the sovereign crisis affecting Greece, Portugal, Ireland and Spain adversely. The latest news from Europe is that Standard and Poor’s has cut Greece’s rating making it the least creditworthy nation. The ratings agency cut Greece’s rating three notches from B to CCC and said the country was likely to default on its debts at least once by 2013. With such anxieties, most of the commodities may come down going forward but gold may remain at elevated levels because of its status as a ‘safe haven’ asset in times of economic woes.

India imports 80 per cent of its crude oil demand making it vulnerable to oil prices. High oil prices increase inflationary expectations in India which in turn adversely impacts India’s growth rate. High oil bill is likely to increase fiscal deficit as the Government is unable to pass on fully the rise in international oil prices to consumers. Diesel, LPG and Kerosene are heavily subsidized in India.

With problems persisting in the Middle East, low inventories and lack of spare capacity, crude oil prices may not come down significantly in the near future unless something dramatic happens in OPEC (the body of oil exporters).

The US dollar index (against a basket of six major currencies, like, Euro, Yen and Pound Sterling) is around 74.5. The US dollar has been weakening against these major currencies in the last six months. However, in the last one week, it has shown some resilience and the index has moved up from lows of 72.5 to the present 74.5. The dollar’s overall weakness is pushing up commodities’ prices to some extent.

Global factors

The Dow Jones is at around 11,950 well below 12,000 after reaching a high of 12,800 recently. The S & P 500 is hovering around 1,270 after reaching a high of 1,360. The US indices have been in a bullish range in the last six to eight months. However, the Asian indices have been mostly in bearish territory. The Shanghai Composite (China) is at a low level of 2,700. The Hang Seng (Hong Kong) index is at 22,500 and Nikkei 225 is at a weak level of 9,400. The FTSE 100 and DAX indices are much stronger at 5,770 and 7,080 respectively.

China is going through its own problems. The non performing assets of Chinese banks are expected to go up significantly in the next one year. The central bank there has been increasing interest rates to tackle inflation. China wants its growth rates to slow down a bit to avoid any hard landing. There are concerns of overinvestment and overcapacity in China’s manufacturing sector. Following the global financial crisis of 2007/2008, China had pumped in huge amounts into its infrastructure and manufacturing sector.

Summary

The Indian Government and the RBI have to tackle inflation both from the fiscal and monetary angles. Some economists have suggested that allowing Indian rupee to appreciate against the US dollar may help in containing inflation in India. The data from RBI indicates that it has not been intervening in the foreign exchange market. The Government and RBI have to take both immediate and long-term measures to tackle inflation head on. However, the Government seems to be in some sort of a gridlock embroiling itself in controversies about how to tackle corruption monster. The general impression is that the Government may not be able to push the economic reforms forward in such a situation. The disinvestment programme seems to be in a limbo. The markets have noticed this policy drift and have been expecting further slide in stock indices. Investors need to be cautious at this point of time. As such, it is not a bad idea to hold some cash and wait for a correction and start buying Indian stocks at Sensex levels of between 16,500 and 17,500.