End of the tightening cycle is nigh

In continuation of its move to normalise the policy rates and narrow the liquidity adjustment facility corridor, the Reserve Bank of India (RBI) has hiked the repo and reverse repo rates by 25 basis points (bps) and 50 bps to 6% and 5%, respectively.

The narrowing of the corridor will help increase the effectiveness of monetary transmission. Overall, RBI’s stance was slightly more hawkish than warranted given the current domestic and global macroeconomic environment.

The domestic environment is characterised by consolidation of economic growth after a sharp rebound and easing inflation. After almost a year of double-digit growth, we expect the Index of Industrial Production to settle at a sustainable level of 7.5-8.5% led by a stronger base year and continued weakness in global demand. Further, the worst on the inflation front is behind us.

Although the Wholesale Price Index is still above RBI’s comfort zone, we expect it to ease to 5.5% by the end of this fiscal, led by good monsoons, easing supply-side pressures, favourable base effect and expectations of continued softness in global commodities. It will also be positively impacted by change in base from 1993-94 to 2004-05 & widening of the basket from 435 to 676 commodities.

With incremental credit growth at 3.3% in FY11 so far, it is not signalling any overheating. It is worth noting that the credit off-take is not broad-based and is predominantly driven by telecom led by one-time 3G payment, power and road sector. The banks have started raising their deposit and lending rates, signalling that the transmission process has begun. While lending rates have gone up by 50 bps, deposit rates have risen by 125-150 bps. The interest rates on the short-term instruments have significantly risen in excess of 150-175 bps.

On the global front, growth remains tepid. The Q2CY10 US GDP growth has been revised down to 1.6% from 2.4% estimated earlier. Further, industry growth has started to moderate across countries and macroeconomic data points from China are also not too encouraging. Given the prevailing uncertainty, proactive central banks of economies with bright growth prospects such as Korea, Russia, Malaysia and Brazil have refrained from hiking rates.

Cumulatively, repo and reverse repo rates have been hiked by 1.25% and 1.75%, respectively in a span of six months, taking it towards neutral rates. With policy rates closer to normal, its transmission process being underway, slowing growth momentum, easing inflation and subdued global economic outlook, directionally, we expect RBI to shift gears towards a moderate policy stance. In fact, at the current juncture, a sustained pickup in the investments is crucial to sustain economic momentum. Besides, due to weak G-3 recovery, a soft policy regime is expected to continue globally, limiting the ability of RBI to hike rates beyond a point. Most probably we will not see any further hike in 2010, with another round of 25 bps hike in repo & reverse repo rates in January 2011. This will likely be the end of the rate hike cycle unless, against the general expectation, inflation worsens from here.

Given the above expectations, coupled with buoyant revenues and windfall gain from 3G & BWA auctions virtually eliminating the probability of government overshooting its fiscal deficit target despite supplementary grant for additional expenditure, we expect 10-year G-Sec yields to rally by 40-50 bps to 7.5-7.6% from the current 8% levels. We also expect its spread from 10-year US government bond to narrow from the current 500 bps, which is 200 bps higher than its 10-year average levels.

The writer is chief investment officer, Birla Sun Life Insurance Co Ltd. Views are personal.