RBI calibrates policy to balance its objectives - Angel Broking

The Reserve Bank of India (RBI) partially rolled back some of the short-term liquidity tightening measures taken to contain forex volatility since July 15. Specifically the Minimum Standing Facility (MSF) rate has now been reduced by 75bp from 10.25% to 9.50% and minimum daily maintenance of CRR has been reduced from 99% of requirement to 95%. The MSF was earlier hiked from 8.25% to 10.25% in mid-July 2013.

In a surprise move, the repo rate has been hiked by 25bp to 7.50% from 7.25%. The RBI has signaled its vigilant stance on inflation through this hike in policy rate and also its stance on the improving external situation through partial easing of the short-end rates.

Temporary v/s permanent measures

Led by positive global cues and improving current account deficit (CAD) fundamentals, the INR witnessed a 5.5% appreciation since the beginning of September 2013. Owing to the recent positive movement of the currency and the Fed's postponement of QE3 tapering, the elevated short-term rates seemed unwarranted to that extent. The RBI has also indicated that in the coming months, the MSF spread over the repo is likely to further decline to 100bp (from 200bp currently). That said, compared to pre-15th July overnight rates of 7.2%, rates are still 2.25bp higher at 9.5%. Hence, the decline all the way back to 7.2% looks unlikely due to factors like a) the current repo hike, b) if inflation persists (necessitating further rate hikes), c) if tight liquidity persists due to global factors which keeps MSF as the operational rate to that extent short-term rates would be prevented from declining all the way to pre-15th July rates.

Market expectations of rates at the long-end now higher than anticipated earlier

Going forward, in case we see the Fed tapering QE3 in the near-term there is a probability that short-term rates would continue to remain high. But on the other hand with stability returning in the forex market and in the event of prolonged continuity of liquidity infusion/ receding concern over capital outflows, we would see a respite in short-term rates as explained earlier. In this context, the RBI itself has indicated at easing of the tightening measures in a calibrated manner with normalization in MSF rate to 100bp above the repo and allowing the liquidity adjustment facility (LAF) repo rate to resume its role as the operational policy interest rate.

Notwithstanding the outcome of Fed's withdrawal of stimulus, rates at the longend are now poised at least 25bp higher than the market's expectations before the monetary policy. This can be attributed to high medium-term inflation expectation maintaining upward pressure on rates at the long-end of the yield curve.

Short term respite, but overall macro outlook for banks remains challenging

As an immediate effect of the RBI measures (reducing MSF rate by 75bp to 9.5% and daily CRR maintenance to 95% from 99%), the cost of funds for more wholesale funded banks would reduce roughly by 10bp on an annualized basis (the reduction in cost across banks would be in congruence with its dependence onwholesale funds). Had these measures not been announced, in our view, the banks with greater reliance on more wholesale funds would have had to further increase lending rates by 25bp at the beginning of 3QFY2014, so as to mitigate the impact of higher costs of wholesale funds on the third quarter's margins. However, as the RBI partly scaled back its liquidity tightening measures, the short term interest rates are likely to come down proportionately and other things being equal the banks are unlikely to need to further increase their base rates at the beginning of 3QFY2014.

Most of the private banks had already revised their base rate upwards in 2QFY2014 so as to mitigate the short term margin pressures emanating from elevated cost of wholesale short term funds. As far as PSU banks are concerned, excluding select banks like SBI, UNBK, BOI, BOM, CNTBK and ANDBK, most others had kept their base rate unchanged during 2QFY2014 until now, even as RBI liquidity tightening measures pushed up their cost of funds (sharply higher for the more wholesale funded ones). Those banks would now have to reassess their base lending rates in light of their ALM reprising situation, persisting elevated short term interest rates (though 75bp lower now than in recent times) and the upward bias to the long term rates emerging from the policy rate increase. Depending upon their current asset liabilities profile assessment (on which we still await clarity from their managements), these banks may choose to either catch up with their private peers or maintain status quo (as further calibration in short term rates is possible even before the next policy announcement).

Overall, at the systemic level, we believe that the long term rates are unlikely to return back to normalcy (to the pre RBI tightening levels) anytime soon and further calibration in short term rates is dependent on the results of the steps taken by Government of India/RBI to put domestic elements in order. Moreover, our current inflation-growth dynamics paints a weak picture of our economy. Consequently, the asset quality pressures for the banking sector are likely to prevail and would continue to dent the sector's performance. Earnings pressures are most likely to further increase due to meaningful marked to market (MTM) losses as bond yields still remain elevated. Though stocks are trading near their historic low valuations, there is no positive catalyst which would warrant a change in our current medium term cautious stance on the banking sector. We recommend investors to avoid PSU banks and stay with the defensives (HDFC Bank is an Accumulate for us). We also like ICICI Bank and Axis Bank, which in our view, offer value over a medium to long term perspective, though we do not rule the possibilities of these stocks undershooting the fair value estimates in the near term, given the fragile macro environment.

Source : Equity Bulls

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