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February 2011

CIO’s Views on RBI Policy and Fixed Income Markets

The genie of inflation is out of bottle but RBI’s policy action clearly indicates its helplessness in containing the damage. Inflation, particularly in primary articles has become very sticky. This can be attributed to a variety of factors including robust demand conditions in India created through loose fiscal and monetary policy post Lehman crisis, number of measures to boost farm and rural incomes and rise in global commodity prices due to a strong cyclical recovery and quantitative easing by central banks. There are signs that the inflation in primary articles can seep into broader level inflation in view of limited supply response in manufacturing sector and labour market. There is a serious risk of a wage-price spiral unless decisive steps on both demand containment and supply augmentation are taken. The effective policy rate (operative rate changed from reverse repo which touched a low of 3.25% to repo rate now at 6.50%) has moved up by 325 bps while systemic liquidity has moved from an excess of over a lakh crore to a deficit of similar amount. In fact, looking at the deposit rates and bond yields, RBI seems to be behind the curve and actually been catching up with the market. So incremental policy actions are unlikely to have much impact on rates. Unfortunately, RBI has always borne the brunt of dealing with high inflation through monetary measures whereas augmenting supply side through policy measures and reducing fiscal deficit are critical in containing inflation and inflationary expectations in India. RBI has also sounded cautious on current account deficit and the financing pattern as it leads to vulnerability on account of volatility in global risk appetite and flows. RBI has rightly mentioned that sustaining credit growth over 20% would be tough given the mismatch in liquidity conditions.

RBI is likely to raise policy rates by another 75 bps over the next couple of months as inflation is unlikely to soften. The next critical event to watch would be Union budget as a high fiscal deficit along with tight monetary policy could seriously impact the growth prospects in FY 12 and beyond. Bond yields are likely to remain range-bound with slightly downward potential and will resume the upward trend post the announcement of Union Budget. Money market rates would be driven by systemic liquidity and demand-supply factors. Though liquidity conditions could improve a bit as government spends (currently sitting on a surplus of Rs. 1.13 lakh crores) over the next 2 months, rates are likely to remain elevated due to constant supply from banks. On the positive side, we believe that deposit growth would continue to inch up given the substantial rise in deposit rates and would ease the pressure on systemic liquidity over a period of time. We strongly recommend investors to take advantage of high money market rates through accrual products like Ultra short term, short term bond fund and fixed maturity plans.

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