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Wednesday, November 03, 2010

Fiscal Situation Appears To Be Comfortable

RBI's Second Quarter Review Of Annual Policy (FY 11) – A Perspective, Santosh Kamath, CIO - Fixed Income, Franklin Templeton Investments 

The following are his comments. 

The second quarter review of the monetary policy was along expected lines, with the sixth straight hike in rates and RBI signaling a pause in monetary tightening in the immediate future. Policy statements indicate inflation remains a top concern, given rising demand side pressures, structural factors in food price inflation and the uptick in global commodity prices. The central bank has expressed confidence in the strength in domestic economic growth and its resilience to global growth slowdown. Measures on the mortgage finance front and steps to enhance the corporate governance mechanism for banks are steps in the positive direction and should boost financial sector health. 

On the economic front, industrial and export data has softened in recent months, and there are some signs of easing in headline inflation levels, but there hasn't been a meaningful dip. Overall, robust economic growth, growing income levels and rising global commodity prices is expected to feed into further rise in prices of consumables as well as assets/ property. As a result, RBI has hiked provisioning rules for teaser home loan rates to 2% (from 1% earlier) and also introduced a cap on loan-to-value (LTV) ratio of 80%. This alongside increase in risk weightages for high value housing loans reflects RBI's cautious stance towards possible asset bubbles. 

Policy statements indicate that the central bank is comfortable with the strong capital flows that are helping in funding the widening current account deficit. However, it is likely to intervene if the flows are beyond the absorptive capacity of the economy. As part of its efforts to strengthen the financial sector, the bank has said that it is looking to prescribe limits on investments of banks in companies engaged in forms of business other than financial services alongside guidelines on compensation practices and corporate governance. It has tightened capital adequacy norms for financial conglomerates. 

Markets

Indian treasury yields eased after comments from the central bank suggested that it is likely to be on hold in the near future as it studies the impact from recent measures and on possible downside risks to growth from the global situation. The rise in short-term rates over the last couple of weeks has been mainly due to the tightness in systemic liquidity. RBI has extended liquidity support measures and announced another round of bond buybacks, which helped ease liquidity pressures and boost market sentiment. 

There was little impact from RBI measures on the equity markets – frontline indices were marginally changed over yesterday levels. Realty stocks were however impacted by concerns the tightening measures could weigh on demand for residential property. 

Outlook

RBI has indicated that it is likely to keep policy rates on hold in the near term as it studies global developments and evaluates the impact of its tightening so far. Given that the trends in food inflation are being increasingly driven by structural factors, the government needs to address the bottlenecks for a longer term solution. RBI measures may have limited effect on this front. Capital flows are likely to continue due to flows into the equity markets, higher FII limits in the debt markets and increased overseas borrowings by Indian entities. 

The fiscal situation appears to be comfortable due to strong tax collections and higher-than-expected non tax revenues and renewed confidence in meeting disinvestment targets. The large equity issuance pipeline and higher demand for credit in the second half of the fiscal, short-term rates could remain firm. At the same time, RBI has also indicated that it will actively manage systemic liquidity to alleviate excessive deficit pressures. Given the spike in short term yields and the central bank indicating a ‘pause', investors can take exposure to fixed income funds focused at the short-end of the curve to benefit from the higher accruals.
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