Monetary Policy Review - June 2018
RBI acts pre-emptively. Post RBI's rate hike, shorter end of the yield curve is relatively more attractive vis-a-vis longer end.
In a surprise move, all six monetary policy committee members voted in favor of a 25-bps hike in repo rate, while retaining its neutral monetary policy stance. This was strikingly different than what the April monetary policy meeting minutes indicated, where two out of six committee members signaled hawkish stance. Dr. Patra had voted for a 25-bps rate hike and Dr. Acharya indicated switching to 'beginning the process of withdrawal of accommodation'. The repo rate now stands at 6.25%, the reverse repo rate at 6.0%; and the Marginal Standing Facility (MSF) rate and Bank rate at 6.50%. The MPC reiterated its commitment to keep headline inflation close to 4 per cent on a durable basis.
RBI revised its projection for CPI inflation to a range of 4.8% - 4.9% in H1 (April 2018 projection range of 4.7% to 5.1%) and 4.7% in H2 (April 2018 projection of 4.4%), including the HRA impact for central government employees (excluding the impact of HRA, CPI projection is 4.6% in H1 and 4.7% in H2), with risks tilted to the upside. The upward revision from April's projection reflects stubbornly high core CPI inflation (ex food & fuel), recent spike in the price of the Indian crude basket has risen by 12% in last 3 months and firming up of input cost pressures due to increase in farm inputs and industrial raw material costs.
The MPC also outlined several factors that make the inflation outlook uncertain on the upside. These include international crude oil prices which has been volatile in the recent period. Revised guidelines for arriving at minimum support prices (MSP) for kharif crops announced in the Union Budget. Rise in RBI's households' inflation expectation surveys which could feed into wages and input costs in the coming months. The staggered impact of HRA increases by various state governments pushing up headline inflation and potentially inducing second-round effects (i.e. inflation in other items due to HRA increases). Whereas, normal monsoon as projected by IMD may help keep food inflation under check. Besides, any further fiscal slippage (both at central and state levels) from the budgeted estimates for 2018-19 may have a significant bearing on inflation outlook.
The central bank retained its GDP growth outlook at 7.4% for 2018-19 but revised its H1 projection to a range of 7.5% - 7.6% (April 2018 projection 7.3%-7.4% in H1) and H2 projection to a range of 7.3% - 7.4% (April 2018 projection 7.3%-7.6% in H2) with risks evenly balanced. Signs of improvement in credit off-take are signifying revival in manufacturing sector and new investment activity. Capacity utilisation has started to see improvement with new orders received by companies last quarter saw a substantial growth over a year ago period, reflecting pick up in domestic demand. Recent pick up in domestic air passenger traffic, services PMI, auto sales is expected to boost consumption expenditure. Export growth is expected to improve further on account of improving global demand, although elevated commodity prices may act as a drag. The process of recapitalization of public sector banks and resolution of distressed assets under the Insolvency and Bankruptcy Code may improve the business and investment environment. However, there are two major risks to the growth outlook. First, protectionist trade measures announced globally. Second, the uncertainty over the pace and timing of monetary policy normalisation by the central banks in advanced economies which may have an adverse impact on capital flows and overall investment sentiment.
Important regulatory measures announced by RBI
Increase in Liquidity Coverage Ratio (LCR) carve-out from Statutory Liquidity Ratio (SLR) available to banks from 11% to 13% is expected to release additional liquidity in the banking system
Further extension of the measure taken by RBI to help banks in reducing the MTM impact of their holding in government securities to the quarter ending June 2018
SDLs to be valued based on observed prices and not at 25 bps above the yield of the G-secs of equivalent maturity
Revised housing loan limits for Priority Sector Lending (PSL) from existing Rs 28 lakh to Rs 35 lakh in metropolitan centers, and from existing Rs 20 lakh to Rs 25 lakh in other centers is expected to help banks meet their PSL requirement
'Haircut' formula for securities pledged under RBI LAF window will change starting August 2018. Margin requirement for Central and State Government securities is reduced. Margin requirement for rated SDLs will be 1% lower than that of other SDLs
Impact on Economy
RBI believes that a broad based economic recovery is in progress as per various indicators outlined above. Their primary concern appears to be the upside risks to inflation due to rising crude oil prices and persistent core inflation. On the back of rising interest rates across short and long-term debt instruments - yields on 12m CPs & CDs have risen by 150 to 175 bps over the last six to nine months, along with a similar rise in yields on corporate bonds & GSecs - banks have started increasing lending rates recently. RBI's repo rate increase may induce marginal rate increases by banks, although the cost of borrowing for corporates has already seen a sharp increase due to the rise in market yields. A broader recovery in demand in the economy would help corporates with lower debt / leverage. But the impact of higher rates on stressed companies remains to be seen.
Impact on Morningstar Model Portfolios
The 10-year benchmark G-sec was trading at around 7.83% before the policy announcement, post which it rose by 9 bps closing at 7.92%. However, further extension of the measure taken by RBI to help banks in reducing the MTM impact of their holding in government securities to the quarter ending June 2018, provided some support to G-sec prices. Yields have moved up around 60-70 bps from the April MPC meeting on back of rise in US treasury yields and crude oil prices. Current spread between 10-year benchmark G-sec yield and repo rate vis-à-vis historical average indicates that market participants have already factored in a second-rate hike of 25 bps.
In our view, RBI has not made a decisive shift towards a tightening cycle by retaining its neutral monetary policy stance. RBI has indicated that future policy action will be data dependent, based on growth inflation dynamics and probably indicating a near term pause. At this juncture, we continue to believe that shorter end of the yield curve is relatively more attractive vis-a-vis longer end. Over the last few quarters, we have completely exited our positions in Long term gilt funds in the model portfolios in favor of short term funds, which in the wake of rising long term Gsec yields, has positively contributed to the performance of the portfolios.