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October 2013

September brought with itself a spring of positive reflexivity addressing most of the expected adversities and in turn, benefiting Indian equities and currency. US Federal Reserve’s decision to delay the tapering of quantitative easing (QE), an agreement with Syrian regime to surrender chemical weapons to UN and re-election of Angela Merkel as German Chancellor with euro skeptics getting less than 5% votes were positive news for the global markets. As a result, FII flows remained strong across emerging markets. Brent crude oil and gold prices corrected 4% and 5% respectively on easing geo-political risks.

Our view had been that the markets were overplaying the Fed 'tapering' episode. That’s behind us and focus has now shifted to the government shut down due to Budget impasse in US. Markets move on from one story to another. Fiscal cliff in US was the story at the beginning of the year as well. Last year, huge volatility was caused by the events in the Euro region and fears of its imminent collapse but now nobody seems to be concerned about it. Same with ‘Abenomics’, name given to the accommodative monetary and fiscal stance announced by the newly elected Japanese Prime minister. The excitement about flood of money from Japan boosting global markets remained short lived. Of late, there has been lot of skepticism on “emerging market growth story” and the global investor would remain anchored to the investing theme that would continue to toggle between relative attractiveness of emerging markets and developed markets.

As the favorable monsoon period recedes, it rains elections in India over the next 6-9 months. So far, the economic agenda has not got eclipsed with the political compulsions. Measures announced in the coal mining and oil exploration sector show continued efforts of the government to get the infrastructure template back to work. It has also successfully navigated its earlier commitment on staggered retail fuel-price hikes. We expect the rural economy to show resilience on the back of good monsoon and possible pre-election spend in the second half of the year.

Macro economic data points released over the last month were mixed with growth data continuing to remain soft while inflation data was higher primarily on account of currency depreciation and elevated food prices. Given the good monsoon and reasonably high buffer stock, food inflation could ease off over the next couple of months. Core inflation remains comfortable. Trade deficit data is taking a turn for the better and we believe the current account is likely to show significant improvement driven by pick up in exports, moderation in imports and higher flows through remittances and invisibles.

The results season would be an important pointer in terms of how corporate India is fine-tuning its operations and balance sheets to retain its flexibility. The depreciated rupee and higher import curbs provide a silver lining for exporters as well as import substitution. This phase where growth might be strained, can fast forward some components of the growth story, like export competitiveness (aided by currency depreciation), improved governance and supply side investments.

The downturn has exposed serious weaknesses in wholesale lending business and we expect a range of reforms on that front. We also need deep, efficient, well-functioning capital markets to channelize savings into financial assets and meet the demand for debt and risk capital for businesses. We have to reduce the dependence on the foreign capital. We are optimistic that the compulsion of current environment and conviction in the vision of new leadership at RBI and other concerned policy makers will lead to an ambitious path of financial sector reforms in India.

The challenges for Indian economy and business are big but not insurmountable. Some of the policy errors and inaction on the execution front had made the cyclical slowdown look like a structural one. However, one

must keep in mind that structural factors driving growth are still firmly in place and India’s institutional capabilities are actually getting stronger. Some of the reforms like Unique Identification number (UID) project, the new companies bill, pension bill, impact of IT infrastructure on improving tax compliance, better transparency through RTI, judicial activism, focus of state governments on growth and governance will have far reaching implications on economy and society. There are a number of tail risks on the horizon and as fund manager we have to remain alert but we recognize the long term macro potential and continue to focus on the bottom up stock picking.

The RBI had instituted liquidity tightening measures in Mid July in response to sharp depreciation in the INR, which resulted in a sharp up move in rates across the curve, apart from keeping the policy rate reductions on hold. The subsequent policy review in July, kept the monetary measures intact while providing a more dovish guidance in terms of policy bias towards supporting growth once external sector situation stabilizes. Receding pressures in the currency market in the weeks leading up to the review had created a potential elbow room for the RBI to gradually unwind the liquidity tightening measures announced since Mid July. The RBI in its latest policy meeting on September 20 did reduce the marginal standing facility (MSF) rate by 75 bps to 9.50%. However, RBI also simultaneously announced a surprise 25 bps repo rate hike from 7.25% to 7.50%. The average daily minimum maintenance of CRR was also marginally reduced from 99% to 95% of the requirement.

RBI has mentioned that keeping a tab on inflation is critical for macro-economic stability and improving the growth potential in the long term. In a sharp contrast to the earlier stance, the broad thrust of monetary policy under Dr Raghuram Rajan seems to focus on inflation and fiscal deficit, which eventually determines the value of the currency. The policy statement announced after the meeting provides a more distinct bias towards adopting an inflation anchor and also differs in terms of not providing a policy guidance, which gives the central bank more flexibility to react to incoming information. The policy guidance remains neutral, even as the RBI looks to eventually align the MSF spread at a markup of 100 bps over the repo rate.

Subsequent to the tightening measures announced since Mid July, the effective operating rate had moved up by 300 bps from 7.25% to 10.25%. The reduction in MSF rate has reduced the near term operational rate by 75bps, which should enable short end rates to settle lower from current levels. In the current context, the monetary policy focus is likely to incrementally turn towards unwinding the exceptional liquidity tightening measures, with additional reductions in MSF and further relaxation in access to LAF. We expect these measures to be contingent on a period of stability in the currency markets and the RBI being able to add on to the foreign exchange reserves through accruals under the FCNR deposit scheme. This is expected to improve systemic liquidity, which may reduce the possibility of RBI OMO purchases at the margin. Considering the global yield levels, improving liquidity and still moderate growth and softening core inflation, long end bond yields may continue to attract sporadic buying interest at higher levels. This may also be helped by prospects of Indian Gilts being added to global bond indices. The trajectory of inflation, especially the Consumer Price Index may determine further moves in the repo rate. In this environment, we could expect a gradual steepening of the curve, with the short end of the curve remaining attractive under the existing risk- return framework. Long bond yields are likely to remain range-bound with incremental demand-supply dynamics dictating the trend in the near future.

Navneet Munot

(Mutual funds investments are subject to market risks, read all scheme related documents carefully.)