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October 2012

RBI Monetary policy and bond market

Despite the market belief that RBI might succumb to pressures and cut policy rates, RBI toughened its stance on inflation and maintained a status quo on rates. The RBI policy action in the recent months has focused on liquidity management given the constraints on reducing the policy rates. The CRR reduction of 25 bps is a pre emptive measure on anticipation of tightening liquidity in the coming months. Liquidity conditions have tightened recently on account  of buildup of Government cash balances and also festive season withdrawals which could accentuate in the coming weeks. The CRR reduction which provides around Rs175 bn of primary liquidity is intended to ensure that monetary policy does not constrain credit for productive purposes. Elevated inflation and the possibility of headline numbers moving up further in the coming months on base effect and also the pass through of recent hikes in administered prices would have weighed in on the reluctance to cut the repo rate. 

The RBI has also revised the growth estimate for FY13 downwards to 5.8% and hiked the WPI estimate to 7.5% which adequately sums up the challenges facing the conduct of monetary policy. The policy guidance offers anticipation of reduction in rates towards the last quarter of FY13 as WPI is anticipated to decline by then. The RBI has reiterated  that the continuation and eventual  execution of reform measures on the fiscal side would provide space for monetary policy to support growth. In the interim, the RBI is likely to resort to OMO’s or additional CRR reductions. Any significant shocks impacting the growth momentum could possibly create space for a rate reduction prior to the last quarter.

We have a benign view on inflation for FY 2013-14 due to output gap in India, soft global commodity prices due to slowdown in China, stable currency, lagged effect of tight monetary policy and our expectation of relatively tighter fiscal policy. This should pave the way for policy easing next year. We maintain a positive view on bonds from a medium term perspective. 

RBI may have to resort to Open market operations to ease liquidity which augur well for the Gsec market. The short end of the curve should remain well supported given the demand supply dynamics and possible RBI intervention to ease liquidity in the system.  In our duration funds (Dynamic and Income fund), we have increased exposure to Gsecs compared to corporate bonds as credit spreads have shrunk.