January 29, 2010

Debt market view post the Third quarter review of Monetary Policy 2009-10

RBI measures

 The Reserve Bank of India (RBI) has today announced a hike in the Cash Reserve Ratio of
Scheduled Banks by 75 bps. This is expected to drain Rs. 36,000 Cr from the Banking
system.
 All other key rates have been left unchanged.
 RBI has clearly continued on the exit path that it has embarked on in October, 2009 policy.
 RBI noted the need to carry forward the shift from ‘managing the crisis’ to ‘managing the
recovery’ stance articulated in October.
 Though inflation is predominantly supply driven, there is an increased risk of spill over in to
a wider inflation. In this context, RBI has hiked its baseline projection for WPI inflation for
end March 2010 to 8.5% from the earlier 6.5% (October policy). Simultaneously, 2009-10
GDP is now expected to grow by 7.5% instead of the earlier 6%.

Our view

 We continue to maintain that bond markets have been, for sometime, adequately discounting
this kind of policy response from RBI on the back of higher inflation, GDP and Industrial
Production numbers.
 However, we recognize that this discounting process has begun much earlier, mainly due to
the record borrowing programme of Government this fiscal. For example, in the last calendar
year, yields on 10-year GOI bond have moved up by close to 3% points despite RBI’s
accommodative monetary stance.
 For the medium term, we feel that the following factors hold the key:
o Government’s budget for the next year – We feel that Government revenues will be
enhanced both on the direct and indirect tax front, thus obviating the need for any
additional borrowing than what the market expects. This fiscal, Government’s net
market borrowing stood at close to Rs. 3.5 lakh crore. While improved Government
finances can prevent a repeat of this kind of borrowing numbers, we feel that the
sheer borrowing size, at some point towards the end of 1st quarter of the next FY, can
cause a spike in yields. At the same time, we recognize that Banking system’s NDTL
growth can provide adequate support to the markets.
o State Government Finances – This could be of some concern next year, especially, if
State Governments revise their pay structures for Government employees. However,
anecdotal evidence on small savings picking up provides some comfort that Sates’
borrowing may not be very heavy. This fiscal, States would be raising about Rs. 1.5
lakh crore from the market.
o Evolving global developments - While continued concerns on US and European
economies and the continued loose monetary policy there has fed in to inflation for
emerging economies such as India, we feel that markets have embarked on a path of
 reversal of high amount of dollar carry trades. This could induce cooling in asset
prices and aid in the control of inflation in emerging economies.
 For the very short term, we remain positive on debt markets as Government borrowing for
this fiscal is to be completed next week and only a small portion of state borrowing remains.
However, we recognize that there is a risk to this borrowing going up, should the
Government fall short of its receipts. At the same time, Government has mentioned that it
would stick to the announced borrowing programme.
 In particular, we feel that in view of RBI’s exit path, short term yields would face continuous
upward pressure. In our opinion, medium term yields (around 5-7 year segment), having
already gone up in response to the record borrowing, offer a good carry and protection
despite rate hikes. We feel that in the current scenario of growth and inflation, investing in
longer term debt is not an attractive option especially given the limited liquidity in that
segment of yield curve.
 In summary, while investment outlook for the short term is guided by the demand-supply
balance, over the medium term we would closely watch the evolution of Government
finances, Budget and Global market developments. We feel that unlike the sharp depreciation
witnessed by bond markets over the last calendar year, going forward, fixed income markets
offer a good investment opportunity (despite some interim volatility based on the evolution
of government finances, RBI actions and global market developments) for investors with an
investment horizon of at least 1 year.

Summary

It is evident from today’s CRR hike of 75 bps that RBI is, in a calibrated manner, moving ahead
on the exit path from an accommodative monetary policy. It is expected that today’s RBI’s
actions would help anchor inflationary expectations and demonstrate its support for the recovery
process without compromising price stability. Notwithstanding some interim volatility over the
next 1or 2 quarters, we feel that unlike the sharp depreciation witnessed by bond markets over
the last calendar year, going forward, fixed income markets offer a good investment opportunity
for investors with an investment horizon of at least 1 year.