HDFC Bank Investment Advisory Group
February 02, 2016
Sixth Bi-monthly Monetary Policy Statement, 2015-16
Monetary and Liquidity Measures:
The Reserve Bank of India (RBI), on the basis of its assessment of the current and evolving
macroeconomic conditions, has decided to:
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keep the policy repo rate under the liquidity adjustment facility (LAF) unchanged at 6.75 per cent;
keep the cash reserve ratio (CRR) of scheduled banks unchanged at 4.0 per cent of net demand
and time liability (NDTL);
continue to provide liquidity under overnight repos at 0.25 per cent of bank-wise NDTL at the LAF
repo rate and liquidity under 14-day term repos as well as longer term repos of up to 0.75 per cent
of NDTL of the banking system through auctions; and
continue with daily variable rate repos and reverse repos to smooth liquidity.
Consequently, the reverse repo rate under the LAF will remain unchanged at 5.75 per cent, and the
marginal standing facility (MSF) rate and the Bank Rate at 7.75 per cent.
RBI’s Policy Stance and Rationale:
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On the inflation front, the RBI expects it to achieve the target of 6 per cent for January 2016
mainly on account factors like receding unfavorable base effect and benign prices of fruits &
vegetables and crude oil.
The RBI also expects that inflation should be around 5 per cent by the end of fiscal 2016-17
based on assumptions of a normal monsoon and the current level of international crude oil
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prices and exchange rates. However, the impact of 7 Pay Commission award implementation has
not been taken into account for factoring in to these projections, which on implementation is expected
to have upward pressure on the rate of inflation for a period of 1-2 years.
On the growth front the RBI has maintained the output growth projections for 2015-16 at 7.4
per cent albeit with a downside bias. For FY 2016-17, GVA growth is projected at 7.6%. The key
risks to growth projections above, however, is expected to emerge from deficient rabi sowing by Janrd
end, consecutive 3 year of weak monsoon, weak domestic private investment, concerns over stalled
projects, excess capacity in industry, sluggish external demand conditions.
Citing the above reasons, the RBI has kept the policy rates unchanged. It will look out for further clarity on
the government policies in its forthcoming Union Budget towards structural reforms while controlling
spending and inflationary development for further monetary policy actions to support growth.
Impact on the Bond Market:
With CPI based inflation for December 2015 at 5.61% and considering moderation in prices of cereals
and vegetables, retail inflation is expected to achieve the 6% target for January 2016. The RBI
maintained its inflation target by March 2017 at 5% without factoring the impact of Seventh Pay
Commission implementation, which RBI believes can pose upside risk on the headline number. The RBI
maintained its growth projections for 2015-16 and 2016-17 at 7.4% and 7.6% respectively. However,
weak domestic private investment, concerns on stalled projects, excess capacity in industry, sluggish
external demand conditions impacting exports demand act as headwinds to the growth projections. More
importantly, RBI will be watchful of the government policies towards its commitment to fiscal consolidation
and how it boosts growth by making structural reforms in the forthcoming Union Budget to provide more
headroom for RBI to ease monetary policies.
In this context, today’s monetary policy was slightly hawkish and thus the forthcoming Union Budget
becomes extremely critical to ascertain the future path for yields of long-term fixed income instruments.
After, today’s monetary policy statement the 10-Year benchmark government bond (7.59% G-Sec 2026)
yield moved up sharply and closed 7bps higher at 7.72%. The 10-year benchmark closed at 7.65%
yesterday.
Over the past couple of months, liquidity conditions have been extremely tight. Excessive government
cash balances with RBI and strong central and state government borrowings have put pressure on the
10-year benchmark yield. At the same time, RBI has provided continuous liquidity through various
overnight and term repos, MSF and at times OMO purchase to limit the higher yield levels. Going forward,
though, February has only one week of central government borrowings; however, liquidity condition is not
expected to ease significantly in the next two months - mainly on account of state government borrowings
(Rs. 605bn – Rs. 665bn in Feb & March 2016), expected lower government spending to manage the
fiscal math, pick up in bank advances and advance tax payment period in March 2016.
The RBI re-affirmed that it continues to be accommodative while awaiting further data on the trajectory of
inflation. Favorable monsoon may help food prices to cool-down resulting headline number to remain
lower. At the same time, lower international commodity prices may support the inflation to remain at lower
levels. However, the risk to inflation emerges from the implementation from Seventh Pay Commission as
well as any spike in commodity prices internationally. Further, the government’s fiscal prudence will be
extremely critical going forward. The fallout of the above can lead to the RBI prolonging the pause in the
monetary policy.
Thus we expect the 10 yr benchmark yields to remain in the range of 7.65% - 7.75% levels in the
near term. Investment into Medium Term funds with an investment horizon of 15 months can be
considered by moderate and conservative investors. Short Term Funds can be considered with an
investment horizon of 12 months. Income/Duration funds can be considered by aggressive
investors for a horizon of 18 months and above, as the bond yields have gone up recently.
Investors looking to invest with a horizon of 1 to 3 months can consider liquid funds and for a
horizon of 3 months and above ultra short term funds can be considered.
Equity Market outlook:
While in the latest monetary policy the RBI has left key policy rates unchanged in line with market
expectations, there seems to be some concerns that is emanating out of the RBI’s language and Inflation
projections, in terms of further room for policy easing. While the RBI has maintained its CPI target of
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March 2017 to 5% and also stated that the impending 7 Pay commission recommendations are not
being factored into the projections, thus leaving an element of upside revision of the CPI target. By its
own admission the RBI is looking at 150-200 bps of real rate of interest in the economy, which, given the
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current repo rate (at 6.75%) leaves little room for movement on the policy rate side if the 7 Pay
Commission recommendations lead to incremental inflation. Also the RBI would be keenly watching the
Union budget, in terms of the measures government takes to manage the fiscal deficit and boost growth
(by investment spending or other incentives) to further take a call on the policy rates. We think therefore
the Fiscal consolidation plan of the government in the Union Budget becomes a key monitorable in the
near term.
From equity market perspective this policy was marginally negative as it suggested to RBI having
little room to cut rates in the near term and also hinting on how the policy rates could move in the
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medium term (as the impact of 7 pay commission gets reflected on the CPI) . On the positive
side, the RBI sounded confident in their concall that once the MCLR (marginal cost lending rate)
based mechanism comes in force; the general interest rates in the economy would be traversing
southwards. We think that this could help the corporates lower their borrowing costs in due
course. Also the focus of the RBI on the banks declaring and providing for the bad loans (or
potential bad loans) would essentially help them to begin on a cleaner slate over the next 12-24
months, with a lower base and improved growth potential. The focus now moves to the
government and its actions in the budget and outside of it in terms of continuing on the reform
process, measures to “crowd in” private investments, managing the fiscal balance and pushing
through key decisions on ease of doing business to help the economy move to a sustainable
growth path. We continue to be positive on our outlook on the equity markets from a 2-3 years
perspective and believe that the current volatility in the markets should be used by the investors
to buy into equities in line with their risk profile.
From equity market perspective we continue to recommend focus into Balanced, Largecap, and
Flexicap Mutual Funds. From a direct equity perspective also, the focus of the investors should be
towards investing into large caps and select midcaps stocks, in line with the investor’s risk
profile. Investment should be made with a horizon for 2-3 years.
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