The Reserve Bank of India (RBI) has reduced the repo rate (the rate at which banks can borrow from the RBI) by 175 basis points (bps) in the past couple of years. This was largely to spur economic growth and in response to the fall in inflation to the range of 4-5% from over 10% in 2013. In the recent months, the slowdown in inflation has intensified after the Narendra Modi-led government announced the demonetization of old INR 500 and INR 1,000 notes on 8th November 2016.
Over the past 18-24 months, we have witnessed banks passing on the benefits of RBI's repo rate cuts to the borrowers. The pace of this transmission was catalyzed by the increased liquidity in November and December 2016, triggered by the government's ban on old currency notes.
In this backdrop, the markets were expecting another 25 bps repo rate cut during the sixth bi-monthly monetary policy review this week. However, the central bank surprised the markets with status quo. Repo rate was kept unchanged at 6.25%. In addition to this, the RBI changed its policy stance from "accommodative" to "neutral", signaling an end to the rate cut cycle. This was mainly due to risks of resurgent inflation due to rising crude oil prices, exchange rate volatility and faster remonetization of currency notes. The bond markets witnessed an immediate knee-jerk reaction, with the yield on 10-year sovereign bond rising sharply from around 6.4% to over 6.8℅ in two days.
A further increase in benchmark yields could lead to costlier loans for companies borrowing from the debt markets. From an investment perspective, higher interest rates in short to medium term could trigger a shift in focus from active duration management to interest accrual strategy. High yielding debt instruments with good credit quality would be favored in this environment.
The equity markets did not witness as much volatility as the debt markets. The Nifty was seen hovering in the range of 8750 to 8800.
^NSEI data by YCharts
The Bigger Picture
The RBI's status quo on both the recent monetary policy reviews (8th February 2017 and 7th December 2016) have taken investors by surprise. While the impact on the equity markets could be short-lived, the markets would keenly be watching the following events and data points.
- Elections in five states - Punjab, Uttar Pradesh, Goa, Uttarakhand and Manipur in February and March 2017. Results of the elections would be announced on 11th March. A victory for BJP, mainly in Uttar Pradesh (the state that elects the highest number of MPs to the Lok Sabha) could increase the central government's hold in the upper house (Rajya Sabha) of the parliament, making it easier to implement their reforms agenda.
- Impact of Demonetization - The government's decision to ban old INR 500 and INR 1,000 notes, that constituted around 86% of the currency under circulation has negatively impacted businesses that were highly dependent on cash-based transactions. The RBI too has lowered the GDP growth forecast for 2016-17 from 7.6% in October 2016 to 6.9% in February 2017. However, the central bank has projected a robust growth of 7.4% for 2017-18.
- Goods & Services Tax Implementation - While the passage of GST bill has been a major success of the Narendra Modi government, implementation of the same would be very crucial.
- Crude Oil Prices - Crude oil prices, which fell sharply to below $30 have rebounded to over $50. Further increase could adversely impact inflation, as India imports more than three-fourths of its oil requirements.
The equity markets (EPI, INDY, SCIF, BATS: INDA , INDL, PIN, INP, INXX, IIF, INCO,SCIN, ICN, SMIN) could be volatile in the short to medium term, owing to both domestic and global factors. However, India as an investment destination looks more attractive than other emerging markets from a long-term perspective, considering its robust growth story.
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