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Friday, October 24, 2008

CRR, Repo Rate hike/cut by RBI and its effects

INDIA, like many other economies, has embarked on a long, difficult road to check runaway prices. It’s now evident that policymakers will hike interest rates till it hurts and pulls down demand. The central bank as well as the government are willing to sacrifice a bit of growth to douse inflation — an issue that has captured the collective imagination.

On Tuesday, the Reserve Bank of India hiked the benchmark short-term rate by 50 basis points, about 25 bps more than what the market had expected. Bonds and equities reacted sharply.

Soon, home loan seekers and corporate borrowers will feel the pinch, since borrowing money will now be far more costly. RBI has not only raised the benchmark repo rate — the rate at which banks borrow from the RBI — from 8.5% to 9% with immediate effect, but has also hiked the cash reserve ratio (CRR) for banks by 25 bps — a measure that will drain Rs 9,000 crore from the banking system.

Given the outright hawkish policy stance, it’s clear that RBI will not hesitate to take more policy actions if he thinks that inflationary expectations have not been adequately checked. However, there is a growing perception that the Indian economy, in its current stage, may be better prepared than before to absorb the rate shocks. Thus, the price it will have to pay would be smaller than feared.

Money market is reflecting interest rates at levels last seen in 1999, a period characterised by a deep slowdown. Some of the more pessimistic analysts predict a bear market of indefinite length and a growth in the region of 7%, though the latter is still high by world standards.

The RBI, however, still expects 8% growth. The optimistic view is that if RBI is able to bring down inflation to 7% by the end of the fiscal — which is its target — the rates can start coming down. However, some forecasts peg inflation as high as 15% by October, which would surely mean higher rates.

BANKS TO HIKE PLRs
Banks are readying plans to raise lending rates by at least 50 basis points over the next few days, keeping in mind the central bank’s message to moderate loan growth.

Most banks will look at revising rates only next month since the rate hike kicks in from August 30. Meanwhile, they will review the liquidity position, hours after the policy review. The prime-lending rate (PLR) of most state owned banks range between 12.75 and 13.25%.

For a long time, these banks had not hiked rates, but now with the rising cost of funds, especially deposits, they do not have the leeway to absorb these costs. Deposit rates are also bound to go up, but the returns will be negative considering that inflation is running at double digits.

MANAGING GROWTH
The RBI is pulling out all stops to ensure that inflation, which at 11.89% is at a 13-year high, can be lowered to 7% towards the end of this fiscal. More importantly, Reddy wants to douse the inflationary expectations. The policy tools, which it put to use while unveiling the first quarter review of the monetary policy, may well strain household budgets and force company managements to re-work their numbers.

Analysts may differ about the growth projections for this fiscal, but Reddy believes that given the healthy investment and savings ratio, the Indian economy can chug along at a decent pace. Capital formation as a percentage of GDP was 35.9% in FY07, while savings grew by 34.8 % in FY07. Even if GDP growth was to temper at 8% in 08-09, India would still be the second fastest growing economy in the world after China.

BANKS GET THE MESSAGE
The Indian banks had grown their loan books at a blistering pace of over 30% in the three years starting from ‘04-’05. Last year, RBI tried to nudge banks to pare lending and focus on credit quality. Yet, some banks had registered a loan growth of well over 30% annually. Banks have been told to review their business strategies to combine long-term viable financing with profitability in operations. Lenders will now have to ensure the health of their loan portfolios, a pre-emptive move to stem any build-up of bad loans with a slowdown looming ahead.

From Auto To Home, Rates To Go Up Across Segments

RETAIL lending rates across most products — auto loans, personal loans, and loans against securities — are likely to go up by, at least, 50 basis points in the coming weeks. But banks may prefer to tread cautiously, as further rate hikes could push up defaults and hit demand. Bad loans have been rising across most retail products in the past few months.

Retail loans are seeing a lower growth in the past few months. It grew by almost 16% as on May 23 compared with 24% the previous year. The two fastest-growing segments in banks’ retail loan portfolio are credit cards and education loans, according to RBI.

Auto loans, which have seen a rate hike of around 1.5% in the past few months, are likely to see another rate hike of 50-75 basis points. Demand has already seen a drop in July.

Defaults in car loans have already seen around a 20% hike in the past one year. Even though rack rates are at around 16%, customer rates are at around 13%. For the past few months, incidentally cash deals have started increasing. Also, down payments by customers have increased.

Bankers are also worried on the fiscal health of dealers in both car and two-wheeler segments, as they feel that some loans are likely to turn bad over the next few months. Already, banks have been reducing loans to this segment for the past quarter.

The two-wheeler segment could see a 50 basis point hike in interest rates. However, bankers are also waiting to see how manufacturers are reacting to the current rate hike. Already rates in this segment are one of the highest at between 24-26%. Delinquencies in this segment have seen a sharp rise with the result that some of the financiers have already gone out of the segment.

In the personal loan segment, rates are already hovering around 19%. This segment is supposed to be a bit more inelastic in demand compared with other retail loans. Bankers are likely to hike rates in this segment by a maximum of 50 basis points. Moreover, defaults are rising even among the higher end of the portfolio. Most bankers concurred that demand for loans have come down by around 15% in July as higher rates have started affecting demand.

NPAs, which were at around 4%, have now risen in some cases to as high as around 7%. Most banks and non-baking finance companies have already adopted a slower growth in this product because of the rising bad loans. Most banks are also likely to increase rates on other secured products like loans against securities.

Put your money where your mouth is

FOR Indian investors, the past three years were stellar in terms of their returns, especially for those with an exposure to equity. However, the equation has changed completely since the start of this year, as oil and other macro-economic concerns have occupied the centre-stage. Managing money has become more complex.

What should you do with your money?
With cash reserve ratio (CRR) rates being hiked by 25 bps and the repo rates by 50 bps, the stock market was bound to react negatively. Post-policy announcement by the Reserve Bank of India, the market entered a sell mode which saw the Sensex losing 557 points to close at 13792. Investors pretty much attuned to getting high returns over the past three years are now wondering where to invest their money.

Direct Equities And Equity MFs
As far as equities go, it has been a bit of a rough ride from the start of this year. Investors have not had it easy, with the Sensex losing as much as 32%. Sectors like real estate and banking have dropped by over 50%. While it is not the time to sell one’s investments, a selective restructuring of one’s portfolio with a bias toward large-caps could be a good idea.

With inflation, interest rates and oil still remaining concerns, equity markets may well remain range bound till the end of 2008. Investments will have to be stock-specific. We would prefer stocks where valuations are cheaper relative to their peers,.

Those investing in equity should have a long-term perspective, simply because of the volatility that could prevail in the short-term. The consensus is that a time frame of less than a year should be avoided. The risk-reward ratio for equities looks favourable from a perspective of a year and a half or two years. Investment in mid-caps and small-caps, if they are made, should be done with a 3-5 perspective.

Debt MF / Fixed Deposits (FD)
Interest on fixed maturity plans (FMPs) and fixed deposits is likely to move up, as banks will be forced to pay more for borrowing funds. If you fall in the higher tax bracket, you could consider liquid funds and FMPs that offer a post-tax return of around 9-9.5% and 10%, respectively. If you fall in the zero-tax bracket, fixed deposits will qualify as a viable option.

Commodities
Hikes in CRR and repo rate result in an economic downturn. Gold also acts as a hedge against inflation. Portfolio allocation to gold can be increased marginally by 5%.

Ulips demand may slow down

THE Reserve Bank of India’s (RBI) monetary measures, which have pushed up interest rates and depressed the stock market, will hit sales of unit-linked insurance plans (ULIPs). With the benchmark BSE Sensex falling by a third after touching its peak of over 21000 points in January 2008, those who have invested in ULIPs in the third quarter of 2007-08 have seen an erosion of their savings.

Insurance companies have managed to record a decent growth because of an expanded distribution network, but sales appear to be easing. Until early 2008, ULIPs have been the main channel for retail investment in the stock market. The measures could see a marginal shift from ULIPs to traditional products. A small shift would be good for us because we have been wanting to reduce the share of premium from ULIPs to around 70% from 85% in 2007-08.

The rise in yields has also given an earning opportunity on the fixed income side. He said that investors do turn cautious about equity investments, when the market turns volatile. But there are income funds under ULIPs as well. But the long-term structural platform of unit-linked investment plans remains intact. And for those not concerned about the short-term volatility in stocks, it is the right time to buy. Premium from new policies has fallen close to 7% for the life insurance industry. This has been largely on account of a decline in sales by LIC. Private companies have grown at over 50%, but their growth has seen a moderation from last year. Private companies are, however, confident that investments in ULIPs will continue to grow.

Floating Rate To Help New Borrowers When The Cycle Turns

NEW borrowers would be better off taking a floating-rate home loan. Despite the fact that the interest rate is likely to go up in the near future. a floating rate still makes sense.

The advantage of a floating rate scheme — where rates move in line with the bank’s benchmark Prime Lending Rate (PLR) — is that the borrower will benefit when the interest rate cycle turns. Thus, in a falling interest rate regime, banks will be under pressure to lower the home loan rates. Lending will not remain as high as it is now. The rate cycle takes a turn every three to five years.

If a borrower is bent on taking a fixed-rate loan, just to avoid uncertainties and possible cash outgo, s/he must carefully read the loan document before signing on the dotted line. Most banks insert a reset clause in the fixed rate home loan agreement. This means that the bank will have the right to revise the home loan rate even if the borrower had opted for a fixed rate. For instance, in case of SBI, the interest rate reset happens at the end of every two years from the date the loan has been disbursed. For Bank of India, the reset is at the end of every five years. HDFC, the biggest home loan player, is among the few lenders with an absolute fixed rate.

However, the difference between the floating and fixed rates is very high — as much as 300 basis points in case of big lenders like HDFC and ICICI Bank. Understandably, most borrowers are discouraged to take a fixed rate loan. More so, because rates will soften once the interest cycle turns after a few years.

Borrowers also have an option to split the loan amount into fixed and floating. Here, a part of the loan is at a fixed rate and the balance is at a floating rate. While many banks offer this, most insist on a reset clause with the fixed rate.

A borrower should look at a fixed rate loan if it’s a 10-year loan and a floating rate if the loan duration is longer. Or, they can go for the part-fix, part-floating option.

Meanwhile, those who have taken loan at floating rates will have to pay more. Most banks are likely to take a call on the rate hike by next month since the CRR hike will come into effect only after a month.

In case of a 20-year loan, a 25-bps hike will mean the EMI going up by Rs 17 for every Rs 1 lakh loan amount; in case of a 50-bps hike, it will be Rs 34 and in case of 75 bps, the EMI will rise by Rs 51. Similarly, if it is a 15-year loan, a 25-bps hike will push up EMI by Rs 16 a month, a 50-bps hike by Rs 33, and a 75-bps hike by Rs 50.

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