The Hindu Business Line : Focus on short-term funds

Reserve Bank of India (RBI) stepped up its efforts to tame inflation by increasing both repo rate and Cash Reserve Ratio (CRR) by 50 bps each. The latest move is a reflection of the reversal in interest rate expectations in 2008. A sharp rise in headline inflation numbers changed the interest rate environment dramatically.

Global scene

Central banks in developed economies cut interest rates and undertook liquidity infusion to ease the impact of the credit crisis earlier in the year. However, the persistent rise in crude oil prices and commodities has resulted in a difficult situation, with inflationary pressures building up and economic growth decelerating. This has resulted in central banks’ primary concerns shifting from growth to inflation risks.

Unlike developed countries, economies in the Asian and emerging markets regions have consistently adopted a tight monetary stance to deal with rising inflation due to commodity and food prices, on the back of relatively higher economic growth. Central banks in countries such as China, South Africa, have been raising interest rates. It is not clear if we have witnessed the peak in terms of commodity prices, bu the high prices have led to political chatter about preventing investors/speculators from investing in commodity markets.

India position

The Indian economy had withstood the rise in oil and commodity prices relatively well helped by strong growth and the absence of full pass through of global energy prices.

However, sustained domestic demand and rising imported inflation have led to a sharp rise in headline inflation numbers since March, leading to a slew of fiscal and monetary measures.

This had culminated in the multi-year high inflation growth numbers released last week and RBI’s 50 bps hike in CRR and repo rates this week. Consequently, yields have moved up sharply across the curve.

On the other hand, the strong capital outflows and concerns about the widening trade deficit have resulted in the Indian rupee losing ground against major currencies. While India’s external position remains strong, helped by large foreign exchange reserves and a relatively low external debt-to-GDP ratio, investors are worried about the impact of increasing value of oil imports and FII outflows on the current account deficit.

On the fiscal front, off-balance sheet items such as oil/fertiliser subsidies, farm loan waiver and possible wage hikes are raising concerns. Despite recent strong trends in advance tax payments; there are also worries about possible revenue pressures due to expected slowdown in the economy

Near-term outlook

The RBI has clearly indicated that aggregate demand pressures have been on the high side, despite the monetary tightening, and appears to be focussed on alleviating inflationary pressures. It has indicated that the key economic drivers – investment and consumption, remain strong, contributing to increased demand.

In such a scenario, global oil prices and inflationary pressures are likely to be the key factors for domestic monetary policy.

Over the near term, monetary policy is expected to retain a tightening bias and any change/pause in current policy direction will depend on inflation.

We expect liquidity to remain tight and, despite the advance tax flows, the CRR hike along with RBI intervention in the forex markets, should remove any excess liquidity from the system. The increased differential between repo/reverse repo rate is in line with the central bank’s stated policy of maintaining a wider band in uncertain times.

The average duration of our portfolios continues to be on the lower side and we are focusing on accrual products. Investors should look to focus on funds such as short-term floating rate funds, FMP and ultra short bond funds.

(The author is CIO, Fixed Income, Franklin Templeton Investments)

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