July 2010

Monetary tightening, rising inflationary concerns, decline in monthly IIP numbers, easing of tight liquidity conditions (helped by huge G-Sec maturities) were the key highlights of the month.

RBI hiked the key policy rates twice during the month maintaining the hawkish stance and giving clear signal that inflation was key concerns now. In fact, RBI revised upwards its FY11 economic growth and FY11 year-end inflation projections. Month started with RBI raising the key policy rates by 25 bps each as an inter-meeting move and month ended with RBI hiking repo and reverse repo by 25 bps and 50 bps respectively in the first quarter policy meeting. RBI also announced that it will conducting mid-quarter reviews. Regarding liquidity, RBI stated that the current tight liquidity helps in effective transmission of monetary policy and would prefer to generate liquidity conditions consistent with more effective transmission of policy actions in future.

After registering impressive growth of 17.6% in April’10, industrial production growth slowed down to 11.5% in May’10, primarily driven down by moderation in capital goods and consumer goods. In fact, latest numbers points to moderating industrial growth momentum. The sequential decline indicates supply constraint and not softening of demand as most sectors are operating at full capacity. India’s lead indicators like, port traffic, railway traffic, PMI, infrastructure sector are showing healthy but slowing growth signs. Going forward, IIP growth will move to a more sustainable level, as inventory restocking ends.

Demand for credit continues to rise. After having declined to below 10% levels in Oct’09, the credit growth has picked up to 17% by Mar’10 and has further increased to 21% by June 16, 2010. The sequential credit in current fiscal year has shown good improvement, following the domestic pickup in industrial activity and investment towards telecom auctions.
Inflation continues to be a major concern. WPI-based inflation has been in double-digit since Feb’10. Inflation rose to 10.55% in June’10 as against 10.16% in May’10 - mainly due to hike in administered fuel and electricity prices and sharp rise in iron ore prices. We expect inflation to remain sticky around current levels over next couple of months. More worrisome is the fact that the inflation is no longer a food prices driven; in fact it has become more generalized. Non-food inflation has increased from close to zero percent in Nov’09 to 10.9% in June’10, contributing 70% to inflation. Similarly, the consumer price index inflation for industrial workers (CPI-IW) continued to remain in double-digit for twelve consecutive months on higher food prices. However it has depicted declining trend since Feb’10 and has come down from high of 16.22% in January 2010 to 13.73% in June’10. Given the rising inflation and inflationary expectations, RBI has shifted its focus from growth to inflation and raised the key policy rates twice during the month.

On fiscal front, the month saw robust revenue generation through direct tax and disinvestment revenues. Direct tax collection grew at 16% in April-July driven mainly by robust corporate tax and income tax. The month also saw successful disinvestment of PSU Engineers’ India. Government collected three times higher amount through the divestment (around US$210 mn) than initially estimated on account of oversubscription.

Despite the robust performance on economic front, the Indian rupee continued to exhibit the declining trend vis-à-vis American dollar since May’10 on the strong US dollar, huge trade deficit and low foreign inflows. INR weakened marginal by 0.5% in June’10 as against 3% in May’10 and by 1.65% in Jun’10 and stood on an average at around 46.83/USD in July’10.
G-Sec market witnessed hardening of yields during July’10. Month started with unexpected hike in key policy rate, which resulted in immediate hardening of yields and thereafter the yields remained range-bound on lower than expected IIP and inflation numbers. Quarterly policy meeting towards the end of month, which reflected hawkish stance of RBI, saw yields sharply rising. Post-policy hike, 10 year benchmark yield jumped by 13 bps to the month end. 10 year benchmark closed the month at 7.80% (previous month’s close: 7.55%).
Taking cues from G-Sec markets, the corporate bond yields harden post policy hikes. 10 year AAA increased to 8.82% by month end from 8.69% in the previous month, while 5 year AAA increased to 8.52% from 8.23% in the previous month. Volumes were robust at Rs. 63782 cr in July’10 vis-à-vis Rs. 54,404 cr in June’10. With this, total trading volumes in corporate bond markets during April-July 2010 is Rs. 2,57, 745 cr, more than half of total trading volumes for entire FY10 (around Rs. 4,01,198 cr). FII investment in debt instruments also increased to Rs. 8106 cr in July’10 from Rs. 740.70 cr in May’10.
Tight liquidity conditions continued to prevail in July’10. The net LAF hovered around negative Rs. 40,000-60,000 cr during the month. As a result, RBI extended its ad-hoc measures to ease liquidity conditions like : i) conducting second LAF on daily basis and; ii) the additional liquidity support to scheduled commercial banks under the LAF to the extent of up to 0.5% of their net demand and time liabilities (NDTL) for SLR purpose. These measures were announced for period up to July 16, 2010. RBI further extended second LAF provision upto month end. RBI also reduced the amount for T-bill auction for 91 days, 182 day and 364 days, which has resulted in providing cushion of Rs. 22,000 cr during the month. Liquidity conditions eased towards the end of month and net LAF became positive on huge G-Sec maturities.
 

Outlook

We expect liquidity to improve during August on increased Government expenditure. Similarly, we expect the G-Sec yields to be under pressure during the month on RBI hawkish stance and huge G-Sec issuance lined up (Rs. 49,000 cr) with no maturities to provide the breather. 10 year benchmark G-Sec is likely to be in the range of 7.80% and 7.95% during the month. Inflation and key policy rate hike expectations are likely to dominate the yield curve in coming months. Fixed income markets are likely to get support in 2H FY11 on lower G-Sec supply, declining inflation and expectations of good monsoon. Higher accruals from 3G and broadband auctions are unlikely to result in lower gross borrowings and are expected to be used for additional expenditure (Government will be spending around Rs. 54,000 cr more as reflected from supplementary grant in the current parliamentary session).

Common Source for Debt Market View: RBI, CMIE, Bloomberg

By: Mr. Prashant Pimple - Fund Manager, Debt.

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