Archive for July, 2010
First quarterly review of monetary policy 2010-11
Highlights of the policy
RBI Governor, Dr D V Subbarao announced the first quarterly review of monetary policy today. The measures taken were quite on the expected lines (Read our article on monetary policy expectations).
- Benchmark Repo rates hiked by 25 bps to 5.75% with immediate effect.
- Benchmark Reverse Repo rates hiked by 50 bps to 4.50% with immediate effect.
- The interest rate corridor between the Repo and Reverse Repo window reduced to 125 bps from 150 bps.
- CRR, SLR and Bank rate kept unchanged at 6%, 25% and 6%, respectively.
- Baseline inflation projection for March 2010 increased to 6% from 5.5%.
- Baseline estimate for GDP growth for 2010-11 revised to 8.5% from 8%.
- Bank deposit growth target of 18% maintained for FY2010-11; Bank deposit growth stood at 15.0% year-on-year as on July 2, 2010.
- Bank credit growth target of 20% maintained for FY2010-11; Bank credit growth stood at 22.3% year-on-year as on July 2, 2010.
- RBI to undertake mid-quarter policy reviews starting September 2010.
Impact of monetary policy
- As expected, RBI has raised the policy rates. This is the fourth rate hike since March this year raising the Repo by a total of 100 bps and Reverse Repo by 125 bps. Moving differently from earlier moves, the quantum of change in the policy rates; repo and reverse repo is different (What are policy rates?). The Liquidity Adjustment Facility (LAF) corridor has been shrunk to 125 bps, a change first time since November’2008.
What this means?
Short term interest rates, particularly, interbank repo market rates hover in between the LAF corridor in order to prevent arbitrage opportunities for the banks. Because of tight liquidity conditions, short term rates have been quite volatile. This measure is aimed at containing this volatility in the rates.
- Since end-May, banks have been borrwoing from RBI through its LAF Repo window. Out of four rate hikes since March, two were effected when there was ample liquidity in th system. But the last two have come at a time when the liquidity conditions have tightened. Thus interest cost of banks will go up. Assuming that banks will borrow about Rs 50,000 cr for the year as whole from Repo, the combined efect of the last two hikes will shave off about Rs 250 cr from banking sector’s profits.
- What would also hurt banks’s profitability is that deposit rates have also risen. Thus lending rates, in general will go up in order to protect net interest margin (NIM).
- Inflationary expectations have driven RBI to raise the rates. Policy stance of RBI has shifted to “to containing inflation and anchoring inflationary expectations”. RBI has noted that inflationary expectations have firmed up. Accordingly, RBI has also raised the projection for end-March 2011 to 6%. RBI has commented that it will continue to take actions to counter inflationary expectation.
- Though RBI has not hinted at further rate hikes, but its strong concern for inflation implies that good growth prospect along with continued high inflation will in make it imperative fro RBI to increase rates.
Author:Praveen Bajaj
RBI likely to raise rates in todays monetary policy review
RBI is going to announce the First quarterly review of monetary policy in some time and unlike last time, expectations are quite clear this time. Last time, in April, analysts were divided in opinions about a 25 bps hike or a 50 bps hike or no action by RBI. But this time, analysts are almost certain that RBI would raise the policy rates by 25 bps taking the Repo rate to 5.75%.
Inflationary concerns
RBI has time and again stressed on its concerns on inflation. In the last policy announcement RBI had anticipated that inflation will come down in a gradual manner. But inflation is still reigning in double digits. For June, WPI increased by 10.6% over last June. Increasingly, it is seen that inflation has become more broad-based and manufacturing as well as fuel price inflation has also been rising. For food articles as well, though the growth rate is moderating, but is still at high levels and is not expected to go down substantially unless new crop comes in the market which would be only towards October. Thus inflationary concerns are quite strong and RBI would like to take some action to tame it.
Economic Growth
Economic activity has continued to grow at a good pace. GDP growth for the last quarter was above 8% and for the next year, the growth rate is expected to be higher than last year. IMF in its last World Economic Outlook (WEO) update has projected a growth rate of more than 9% for India in the current year. In recent months, IIP has moderated but is still growing by double digits and some sectors in IIP are showing very good growth. Monsoon has been good till now implying that agricultural growth will also be good and give a boost to the farm income and rural spending levels. This will support RBI’s decision to raise rates.
Liquidity and interest rates
Liquidity conditions have tightened significantly since the last policy announcement. Since May end, when telecom companies made 3G and Broadband wireless access (BWA) payments to the Govt, liquidity has dried up. Banks have been borrowing on an average above Rs 50,000 cr from RBI from its two repo windows on a daily basis. Short term rates (90 day Commercial paper, 90 day T-Bill, call rates) all have moved up. Long term yields, though had come down by about 50 bps from the levels seen in April, but after the July 2 hike in policy rates have hardened by about 20 bps.
In a short time, Dr D V Subbarao is going to announce the First quarterly review of monetary policy and he likely to increase the policy rates by 25 bps.
Author:Praveen Bajaj
Overnight Index Swap 3 – Uses of OIS
This article is part 3 of the series on Overnight Index Swap. To see first part of Overnight Index Swap series click
Users of Overnight Index Swap
As per RBI guidelines, banks, financial institutions, primary dealers and corporate have been allowed to transact in OIS
Uses of Overnight Index Swap
Asset liability management
Many a times banks and other institutions run asset liability mismatch such as having cash surplus with long term liabilities and lacks assets. Thus they have to lend overnight resulting in lesser returns on funds and runs the risks of fluctuations in overnight rate. This can be mitigated by OIS. It can sell and OIS thus receiving fixed rate and pay O/N rate and continue to lend in overnight market. Thus the risk is mitigated at the same time results in higher returns and liquidity to the institution.
Phase 2 of IFRS 9: Exposure Draft on Amortised cost and Impairment
Further to our earlier explanation of IFRS 9 (click here to read), our analyst Shalini Tibe comments on the exposure draft of IFRS 9. We hope the information is useful to you.
Exposure Draft (ED) proposes to replace Incurred Loss Model for the assessment of impairment of financial assets measured at amortized cost currently included in IAS 39 with Expected Loss Approach that enables earlier recognition of credit risk.
Incurred Loss Model has been criticized because of following reasons:
Expected losses are implicit in initial measurement of assets but are not taken into account when determining the Effective Interest rate used for subsequent measurement.
This results in a systematic overstatement of interest revenue in the period before a loss event occurs. In effect, subsequent impairment losses are in part reversals of inappropriate revenue recognition in earlier periods.
If suppose ABC Bank has given loan of Rs.100, 000 @ of 10 percent P.A. for 5 years then following will the schedule for interest repayment:
| Year | Interest to be accounted
in P & L a/c (Rs.) |
| 1 | 10,000 |
| 2 | 10,000 |
| 3 | 10,000 |
| 4 | 10,000 |
| 5 | 10,000 |
Under Incurred loss approach 10 percent interest rate includes expected loss factor which is accounted in Profit and Loss account as interest revenue.
Impairment loss is accounted only after a loss trigger is indicated. Thus there is an overstatement of interest revenue in the period before a loss event occurs.
.
Thus ED has come out with Expected Loss Approach.
Expected Loss Approach (ELA)
- An entity would have to estimate the expected credit losses over the life of asset on initial measurement of the asset.
- No gain or loss would be recognized at inception of the asset.
- The expected credit loss would be incorporated into Effective Interest rate (EIR) and consequently reduces EIR.
- Expected Cash flows (ECF) have to be determined at each measurement date and any gain or loss on subsequent reassessment would have to be recognized immediately in statement of Comprehensive income i.e. Profit and Loss a/c.
The proposed impairment model of ELA generates changes in Effective Interest rate (EIR) to include Expected loss rate in EIR calculation. Mingling of credit risk and credit rate would be difficult and costly to implement and generate significant operational challenges when it comes to practical implementation.
The operational aspects of applying the expected loss approach that requires historical information may not be available with all the entities.
ED proposes that Expected cash flows may be estimated on a Portfolio basis or on Individual basis.
A financial asset can be moved from Portfolio basis to Individual basis or vice versa. Whatever basis chosen, it shall provide the best estimate of Expected cash flow as per ED.
In case of Portfolio basis, Financial assets shall be grouped with similar credit risk characteristics that are indicative of the debtors ability to pay all the contractual amounts when due.
Amount of Expected credit loss would be more reliable when determined on portfolio basis and when based on statistical assessment. Loan portfolio contains a global credit risk exposure that can be estimated with certainty where as for each individual loan granted it will remain unpredictable.
Practically also expected losses can be determined at portfolio level. Because when we are looking at portfolio having similar credit risk characteristics, we can determine that some contractual cash flow will not be received although it may not be known at that point of time which specific asset will not perform.
In contrast entities in respect of individual loan at inception will estimate that it will receive full contractual payment over its term.
Thus International Accounting Standard Board (IASB) shall consider applying Expected loss model on portfolio basis.
IASB plans to issue final standard on amortized cost and impairment in the forth quarter of 2010. However the IFRS implementation date for is January 1, 2013.
Author: CA Shalini Tibe
Bond market/ G-Sec update
Yields on Government securities rose to the highest level in two weeks following the mid-term 25 bps rate hike by RBI on last Friday. Benchmark 10 year bond, 7.80% 2020 security rose 8 bps to 7.64% from 7.56% close of last week.
As expected, yields opened stronger on Monday, but later were dragged down due to buying in the securities. Due to reduced fiscal deficit, RBI had announced a reduced borrowing last week. Same was expected for the week as well. But RBI announced the issue of securities worth Rs 12,000 cr. Along with this, rally in US treasuries kept the sentiments up in bond market. Yields weakened till 7.57% on Wednesday.
Liquidity conditions eased slightly compared to the last week. Amount borrowed from RBI’s repo window averaged above Rs 50,000 cr for the week. Indian Financial Services Secretary R Gopalan commented that liquidity crunch in the Indian banking system was expected to ease in the next 10-15 days.
Benchmark 10 year bond daily movement
However, with the release of stronger weekly inflation figures, yields again started hardening. the primary articles index moved up by 1.4% marking a YoY inflation growth of 16.08% as compared to 14.75% observed a week earlier. The Fuel and power index rose steeply by 4.5% taking the inflation rate to 18.02% compared to 12.9% a week earlier. The index factored in higher prices of petrol, diesel, kerosene and LPG as announced by the Government on June 25th.
Markets clearly are factoring in another rate hike at the July 27 announcement of First quarter review of monetary policy. All fixed income market rates have hardened. While commercial paper rates were seen hardening since June beginning, G-sec rates have started hardening recently. Next week we have Index of Industrial Production (IIP) and WPI monthly release both of which would be important guiding factor for RBI to decide on interest rates.
To read earlier updates click here
Author:Praveen Bajaj
What moved Sensex
Among expectations of good Q1 results, equity markets cheered this week with gains of 2.1% or 373 points for the week to close at 17,833 following a 0.6% loss last week.
Markets had lots of good news this week. IMF raised the projections for Indian growth rate for the year 2010 to 9.5% citing reasons like favourable financing conditions and robust corporate profits to drive expansion. For the year 2011, the forecast has been kept at 8.5%.
Progress of monsoon has been closely watched. IMD announced that monsoon has covered the whole of India about 10 days before schedule was taken favourably by the markets. Southwest monsoons are important for the agricultural sector of the economy as well is instrumental in containing the food prices which have been cause of concern since last year when monsoon was deficient.
Telecom sector saw considerable upside this week after a rating upgrade by Credit Suisse. A note from Credit Suisse said that concerns on competition, regulation, 3G auction fee and RIL’s entry have been overstated. Bharti Airtel rose 16.6% for the week.
Sugar sector gained after comments from Sharad Pawar regarding decontrolling the sugar prices.
Expectations of good Q1 numbers from companies are also driving the prices. Advance tax numbers have hinted at robust earnings.
Companies will start releasing Q1 results from next week onwards. Most of the good news has already been factored in the prices. Any results above the estimates will lead to more gains in the respective stocks. Two most important numbers from Govt viz IIP and monthly inflation figures will be released next week and will be closely watched.
To read earlier equity updates, click here
Author: Praveen Bajaj
European Central Bank (ECB) in 2008 = RBI in 2010
I am sure that the subject of my article would be very confusing for some of you or may be strange for a lot of you. What I am trying to convey with this one is again some graduation level economics which I studied during my Macroeconomics paper in 2005, which I believe the world central bank’s heads are forgetting or trying to overlook over more complex understandings.
The core objective of any Central Bank is to do a through analysis of the forthcoming economic situation of an economy (growth and inflation) and accordingly adjust the liquidity flow into the system. It also involves taking into account any major local or global events that could shape up the economic situation in the country and hence being prepared for the same.
Thus, in nut shell I would say that the core objective of any monetary policy is to manage liquidity into the system so that the economy grows (with minimal inflation), but this decision should be based on ex-ante analysis and not ex-post analysis.
This precise mistake I believe ECB committed in July 2008. In July 2008, when the global credit crisis was almost about to reach its peak, the global growth outlook was bleak and most of the central bank’s around the world were either growing through rate cuts or on the verge of doing so, ECB announced a rate hike of 25 bps, which as per experts is one of the many important reasons of the current EU turmoils. The move as said by Mr. Trichet was” mainly on account of “heightened concerns at the ECB about inflation in Europe”.
The inflation which was just a temporary phenomenon in EU because of the high commodity prices, made ECB think beyond the US Sub-prime and Global credit crisis and took a rate hike decision, saying that “the crisis was one belonging to US and will not have impact on EU”. Thus in October when the US crisis started spreading wide the EU was down of out because of the decision in July.
The same is what RBI has done on Friday, going by its ex-post and probably present rate hike analogy has gone ahead with a rate hike. Its done probably at a time when the Indian banking system is already crunched for liquidity because of 3G and BWA auctions, can have a long repercussion. The RBI also said like EU said in 2008 that“Inflation is a bigger concern than EU Crisis”.
Thus going further, I strongly believe that if this EU crisis spreads more (which has high chances) Indian economic growth and more importantly the stock indices could see a blood bath. The Indian markets as of now is quite insulated from the global turmoil, but like EU in 2008 this move by RBI on Friday could lay the foundation for a big Index correction.
Author:Rahul Sonthalia, Research Head, Kredent
Capital Gains Tax
This is the second article in the series of discussion related to Direct Tax Code. The first article was -
Brief On Revised Discussion Paper For Direct Tax Code (DTC) For Minimum Alternate Tax (MAT)
Capital Gain Tax
Brief On Revised Discussion Paper For Direct Tax Code (DTC) For Capital Gains
Current Situation:
Short-term capital gains (STCG) arising on transfer of listed equity shares or units of equity oriented funds are being taxed at 15% and Long term capital gain (LTCG) arising on transfer of listed equity shares or units of equity oriented funds are exempt from tax.
Proposed in DTC:
- Under DTC distinction between short-term investment asset and long-term investment asset on the basis of the length of holding of the asset have been eliminated.
- Income under the head Capital Gains will be considered as income from ordinary sources in case of all taxpayers. It will be taxed at the rate applicable to respective taxpayer.
- Currently for Non resident Income under the head Capital Gains is taxed at nil rates if held for more than 1 year.
- Under DTC in case of non resident Income under the head Capital Gains will be considered as income from ordinary sources and will be taxed at the rate of 30%
Limitation of Capital Gain Tax as proposed in DTC
- The withdrawal of the current scenario of charging 15 % for STCG and LTCG exempt regime will raise the tax liability and may cause fluctuations in the capital market.
- Also charging at the rate of 30 percent is very high as compared to nil rate. Foreign Institutional Investors play a significant role in the Indian capital market. Various countries, including emerging markets, offer non-residents a special tax regime to attract investments and promote depth of capital markets.
Proposed in Discussion Paper for DTC:
- Income under the head Capital Gains will be considered as income from ordinary sources in case of all taxpayers including non-residents. It will be taxed at the rate applicable to that taxpayer.
- In case of listed equity shares or units of an equity oriented fund held for period of more then 1 year Capital Gain will be computed after allowing a deduction at a specified percentage of capital gains without any indexation. This adjusted capital gain will be included in the total income of the taxpayer and will be taxed at the applicable rate. The loss arising on transfer of such asset held for more than one year will also be treated in similar fashion.
- For instance: If the capital gain before deduction at the specified rate comes to Rs.100, it would stand reduced to Rs.50 (if the specified deduction rate is 50 percent). The capital gain of Rs.50 would then be included in the taxpayer’s total income and taxed at the applicable rate. In this example, for a taxpayer in the tax bracket of 10%, such gain will bear an effective tax at the rate of 5% and for taxpayers in tax bracket of 20% or 30%, the effective tax rate would be 10% or 15% respectively.
- In case of Capital gains on other asset held for more than one year the base date for determining the cost of acquisition will now be shifted from 1.4.1981 to 1.4.2000. As a result, all unrealized capital gains on such assets between 1.4.1981 and 31.3.2000 will not be liable to tax. The capital gains will be computed after allowing indexation on this raised base. The capital gains on such assets will be included in the total income of the taxpayer and will be taxed at the applicable rate.
- The Capital gain arising from transfer of any investment asset held for less than one year from the end of the financial year in which it is acquired will be computed without any specified deduction or indexation. It will be included in the total income and will be charged to tax at the rate applicable to taxpayer.
Sector focus: Pharma
Pharma Sector to Outperform in 2010
In an earlier article – July Could be Jittery For the Markets - about equity market, our analyst Rahul advised you to be cautious while investing in equity market in the month of July (click here to read). Thus it becomes extremely important to select the sector in which to invest. Rahul again comes to your rescue with his views on pharma sector
- The share of top 20 pharma companies in India including global MNCs today is around 58% with takeovers and mergers happening fast over the last few years
- Even more acquisitions are on the cards, as the Indian pharma sales are expected to more than double in the next 5 years
- The recent acquisition of Piramal Healthcare’s formulation business by the US based Abbott Lab at almost 9 times Piramal’s Sales at $ 3.72 bn has made headlines
- Within next 2 years patents worth more over $70 bn would expire and this will also give huge oppurtunity to the Indian generic makers
- A recent study carried out by HDFC Securities identifies 34 Indian companies as having positioned themselves to tap this emerging opportunity
Dr Reddys could be one of the key benefeciaries of this
Thus, I believe that the Indian pharma space offers good investment oppurtunities for long term investors, since it offers a blend of both growth and defense and this ongoing consolidation act can also lead to good short team positive surprises for investors. Some of such stocks in the space is Novartis India Limited, Glenmark Pharama, Lupin, etc. Will update you all in details regarding them in details sometime later.
Author:Rahul Sonthalia, Research Head, Kredent
