As widely expected, the Reserve Bank of India, or RBI’s, Monetary Policy Committee, or MPC, left policy rates unchanged citing lower than expected inflation prints in recent times. Although, it retained its stance of calibrated tightening of monetary policy in line with the objective of achieving the medium-term target for consumer price index, or CPI, inflation of 4 % within a band of +/- 2 %, while supporting growth. While the decision on keeping the policy rate unchanged was unanimous, Dr. Ravindra H. Dholakia voted to change the stance to neutral. Consequently, the Repo rate remains at 6.5%, the reverse repo rate under LAF at 6.25 % and the Marginal Standing Facility and Bank rate at 6.75 %.
The central bank reduced its inflation forecasts over the next three quarters. In the fourth bi-monthly policy of October 2018, CPI inflation was projected at 4 % in Q2:2018-19, 3.9-4.5 % in H2 and 4.8 % in Q1:2019-20, with risks somewhat to the upside. The actual inflation outcome in Q2 at 3.9 % was marginally lower than the projection of 4.0 %. However, the October inflation print at 3.3 % turned out to be unexpectedly low. Lower than expected food inflation, sharp drop in crude oil prices and appreciating bias in EME currencies including the INR have contributed to lower than expected inflation prints in recent times. On the other hand, non-food inflation has been rising.
Considering these factors along with an assumption of a normal monsoon in 2019, inflation is projected at 2.7-3.2 % in H2:2018-19 and 3.8-4.2 % in H1:2019-20, with risks tilted to the upside. In terms of economic growth, GDP growth projections for 2018-19 have been retained at 7.4% (7.2 to 7.3% in H2) as in the October policy and for H1 2019-20 at 7.5% with risks somewhat to the downside.
Overall, the MPC noted that the benign outlook for headline inflation is driven mainly by the unexpected softening of food inflation and collapse in oil prices in a relatively short period of time. Excluding food items, inflation has remained sticky and elevated, and the output gap remains virtually closed. The MPC also noted that even as escalating trade tensions, tightening of global financial conditions and slowing down of global demand pose some downside risks to the domestic economy, the decline in oil prices in recent weeks, if sustained, will provide tailwinds. The acceleration in investment activity also bodes well for the medium-term growth potential of the economy. The time is apposite to further strengthen domestic macroeconomic fundamentals. In this context, fiscal discipline is critical to create space for and crowd in private investment activity.
RBI also re-iterated its stance on providing adequate liquidity to the banking system by conducting by OMOs over the next few months to address the negative impact of foreign exchange operations (selling USD) on rupee liquidity.
Separately, as part of its review of the developmental and regulatory policy measures, the RBI announced a number of changes. Couple of important ones include: 1> External benchmarking of new floating rate loans by Banks instead of the present system of internal benchmarks such as Prime Lending Rate, or PLR, Benchmark Prime Lending Rate, or BPLR, or Marginal Cost of Funds based Lending rate, or MCLR. It is proposed that all new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans to Micro and Small Enterprises extended by banks from April 1, 2019 shall be benchmarked to one of the following: i> Reserve Bank of India policy repo rate, or ii> 91 days Treasury Bill yield or iii> 182 days Treasury Bill yield, or iv> Any other benchmark market interest rate produced by the FBIL. The spread over the benchmark rate – to be decided wholly at the Banks’ discretion – should remain unchanged through the life of the loan subject to certain factors.
2> It also decided to reduce the SLR by 25 bps every calendar quarter from 19.5% to 18% of NDTL. The first reduction of 25 bps will take effect in the quarter commencing January 2019.
Our view
Clearly, recent subdued inflation prints, particularly food inflation and the sharp drop in crude oil prices, have surprised not only economists but the RBI as well. As per their stated objective, RBI would like to see inflation prints at 4% or lower on a durable or consistent basis before making a policy decision. Accordingly, it appears that RBI may watch incoming data on inflation and growth over the next couple of quarters before enacting any changes in policy rates. If inflation prints remain in line with or below their revised forecasts, the first step may be to change the stance from ‘calibrated tightening’ to ‘neutral’. Over the past couple months, long term bond yields have witnessed a sharp drop from levels of 8.15% (10-year GSec) to 7.45% (after today’s policy announcement), in line with lower inflation prints and fall in crude oil prices.
Short term corporate bond yields including those of NBFCs and HFCs have risen significantly over the last three months on the back of rating downgrades and liquidity tightness in the credit market. Spreads on 3-5 year corporate bonds over G-secs have widened meaningfully, which are now above long-term average (5 years) and close to levels seen in 2013.
The 3-year AAA rated corporate bond spread over G-sec is around 110 bps (5-year average is 74bps) and that of AA and A bonds over AAA rated bonds are around 70 bps and 260 bps vis-a-vis 5-year average of 47 bps and 188 bps. Attractive YTM offered by credit risk funds given recent widening of spreads might lure investors to park money within this category. However, one needs to be mindful of the prevailing liquidity stress in the credit market before entering this space. Whereas, better liquidity and relatively attractive spreads on AAA rated short-term bonds, makes an appealing case for high quality short-term bond and corporate bond funds from a risk-reward perspective.
In line with our view, we continue to hold short-term and corporate bond funds with superior credit quality in our model portfolios. As stated earlier, RBI might continue to be on a prolonged pause unless crude oil prices move up significantly and/or food inflation sees reversal. Based on our assessment, shorter end of the yield curve continues to look more attractive than longer end and we’ve positioned our portfolios accordingly.
