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RBI Action

February 9, 2017
Benchmark - 10 year G-sec yield rose sharply post the RBI
policy Monetary Policy Update (February 2017)
7.8
7.5
WHATS CHANGED
7.3 Repo Rate ............................................................................................ Unchanged at 6.25%
7.0 CRR........................................................................................................... Unchanged at 4%
6.8
SLR .................................................................................................... Unchanged at 20.75%
6.5
6.3
6.0 Outlook cautious on change in rate stance
Sep-16

Dec-16
Oct-16
May-16

Jul-16
Aug-16

Nov-16
Mar-16
Apr-16
Feb-16

Feb-17
Jan-17
Jun-16

Though RBI maintained status quo on policy rates, the change of policy
stance from accommodative to neutral should be noted to assess how the
transitory effects of demonetisation on inflation and the output gap play
Source: Bloomberg, ICICIdirect.com Research out. However, there remains room for further transmission as the RBI has
CPI inflation well below RBI target range undertaken a 175 bps rate cut since January 2015, while banks have done
weighted average pass-on of ~85-90bps.
7.0
Also the committee believes the environment for timely transmission of
6.1
5.8
5.8
5.7
5.6

5.5
5.4
5.4

5.4

6.0 policy rates to banks lending rates will be considerably improved if (i) the
5.3
5.3

5.1
5.0

5.0
4.9

4.8

banking sectors nonperforming assets (NPAs) are resolved more quickly


(%)

4.4

5.0
4.3
4.2

and efficiently; (ii) recapitalisation of the banking sector is hastened; and,


3.7
3.7

3.6
3.4

4.0
(iii) the formula for adjustments in the interest rates on small savings
3.0 schemes to changes in yields on government securities of corresponding
May-15

Nov-15

May-16

Nov-16
Mar-15
Apr-15

Aug-15

Mar-16
Apr-16

Aug-16
Feb-15

Feb-16
Jan-16
Jun-15

Jun-16
Sep-15

Sep-16
Dec-15

Dec-16
Oct-15

Oct-16
Jul-15

Jul-16

maturity is fully implemented.

Source: Bloomberg, ICICIdirect.com Research Key policy statements.


The RBI has maintained repo rate, CRR and SLR at 6.25%, 4% and
20.75%, respectively;
Hence, reverse repo rate under LAF, remains unchanged at 5.75%,
with marginal standing facility (MSF) rate and bank rate at 6.75%
GVA growth projection for 2016-17 has been further lowered by 20
bps to 6.9% from 7.1%. Growth is expected to recover sharply to
7.4% with risks evenly balanced in 2017-18, on account of several
factors.
Inflation is projected in the range of 4.0 to 4.5% in the first half of the
financial year and in the range of 4.5 to 5.0 % in the second half with
risks evenly balanced around this projected path. s
View
Banks are still flush with liquidity on account of a sharp surge in deposits
and after their sharp cuts in MCLR. It will take time for further rate cuts by
banks. Credit demand may remain muted in the near term as it takes time
for remonetisation effects to materialise and retail activity again picks up.
Accordingly, the banking sector may remain neutral to positive with the
rate cut stance moving to neutral. Changing the view point to flexible, the
RBI has created room for moving in either direction on rates, with
uncertainties on US macroeconomic policies remaining high over the next
Research Analyst few months.

Sachin Jain
sachin.ja@icicisecurities.com
The change in rate stance came as a surprise to the market particularly in
the wake of weak growth outlook post demonetisation. The focus of
Vishal Narnolia achieving the medium term CPI inflation of target of 4% also looks difficult
vishal.narnolia@icicisecurities.com as CPI inflation is expected to be around 4.5% by the end of the next
Vasant Lohiya
financial year. All these warrant a cautious outlook on G-sec yields in the
vasant.lohiya@icicisecurities.com near term.

ICICI Securities Ltd | Retail Equity Research


Benchmark 10 year G-sec yield has seen a sharp up move of around 25
bps post the policy announcement and is trading at around 6.70%. G-sec
yield is likely to remain under pressure in the near term. However, we do
not foresee major movement from the current levels and believe that
benchmark 10 year G-sec yield is likely to trade in a range between 6.5%
and 7.0%. Bond markets are likely to focus on the extent of growth
deterioration. If it falls more than expectations, the buoyancy in the market
may return.
Stance on inflation...
Excluding food and fuel, inflation has been unyielding at 4.9% since
September. While some part of this inertial behaviour is attributable to the
turnaround in international crude prices since October which fed into
prices of petrol and diesel embedded in transport and communication a
broad-based stickiness is discernible in inflation, particularly in housing,
health, education, personal care and effects (excluding gold and silver) as
well as miscellaneous goods and services consumed by households.

The committee is of the view that the persistence of inflation excluding


food and fuel could set a floor on further downward movements in
headline inflation and trigger second order effects. Nevertheless, headline
CPI inflation in Q4 of 2016-17 is likely to be below 5%. Favourable base
effects and lagged effects of demand compression may mute headline
inflation in Q1 of 2017-18. Thereafter, it is expected to pick up momentum,
especially as growth picks up and the output gap narrows. Moreover, base
effects will reverse and turn adverse during Q3 and Q4 of 2017-18.
Accordingly, inflation is projected in the range of 4.0-4.5% in the first half
of the financial year and in the range of 4.5-5.0% in the second half with
risks evenly balanced around this projected path. In this context, it is
important to note three significant upside risks that impart some
uncertainty to the baseline inflation path the hardening profile of
international crude prices; volatility in the exchange rate on account of
global financial market developments, which could impart upside
pressures to domestic inflation; and the fuller effects of the house rent
allowances under the Seventh Central Pay Commission (CPC) award,
which have not been factored in the baseline inflation path. The focus of
the Union Budget on growth revival without compromising on fiscal
prudence should bode well for limiting upside risks to inflation.
Exhibit 1: Repo rate kept unchanged

9.0
8.0
7.0
6.0
(%)

5.0
4.0
3.0
Oct-10

Jun-11

Oct-11

Jun-12

Oct-12

Jun-13

Oct-13

Jun-14

Oct-14

Jun-15

Oct-15
Feb-11

Feb-12

Feb-13

Feb-14

Feb-15

Feb-16

Reverse Repo Repo rate CRR

Source: RBI, ICICIdirect.com Research

ICICI Securities Ltd | Retail Equity Research Page 2


Fixed income outlook
The Union Budget actually turned out to be a non-event for the fixed
income market. The government stuck to its path of fiscal consolidation
targeting fiscal deficit at 3.2% of GDP in FY18 from 3.5% in FY17. The
gross borrowing programme for FY18 at | 5,80,000 crore was slightly
better than market expectation.

From a structural medium-term perspective, the government has accepted


the recommendations of the FRBM review committee to reduce the debt
to GDP ratio to 60% by 2023 (consisting of 40% for central government
and 20% for state governments). The debt to GDP ratio in 2016 was at
68.5%. The government has also accepted the fiscal deficit target
recommendation of 3% of GDP in FY19.

Although gross borrowing from the central government has remained at


current levels in the last few years, the borrowings from state governments
have increased significantly over the last few years.

Exhibit 2: Share of state government borrowing consistently increasing in last few years

90% 79% 1200000


79% 78%
80% 72% 69% 1000000
70% 63%
60% 55% 800000
50%
37% 600000
40% 28% 31% 45%
30% 21% 21% 22% 400000
20%
200000
10%
0% 0
FY12 FY13 FY14 FY15 FY16 FY17 FY18

Total Borrowings (|)(RHS) Centre Borrowing % of Total Borrowings (LHS)

State Borrowing % of Total Borrowings (LHS)

Source: Economic Survey

Historically, it has been observed that years of good returns in G-Secs are
followed by lower returns.

ICICI Securities Ltd | Retail Equity Research Page 3


Exhibit 3: Historical trend in return from G-Sec indicates, going forward, return likely to be lower
Allocation to pure G-sec or duration funds should be
30
avoided given their historical outperformance and G-sec
yield trading at the lower end of its historical range. Crisil 25
10 year gilt index has delivered 38% return in the last 20
three years. It is likely the return will be significantly
lower, going forward 15
%
10

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016
-5

-10

-15
Crisil 10 Yr Gilt Index returns

Source: Economic Survey

Given the hawkish stance by RBI and low absolute levels of G-sec yield,
allocation to duration or G-sec funds should be limited given limited room
for further rally in G-sec yields.

ICICI Securities Ltd | Retail Equity Research Page 4


RATING RATIONALE
ICICIdirect.com endeavours to provide objective opinions and recommendations. ICICIdirect.com assigns
ratings to its stocks according to their notional target price vs. current market price and then categorises them
as Strong Buy, Buy, Hold and Sell. The performance horizon is two years unless specified and the notional
target price is defined as the analysts' valuation for a stock.

Strong Buy: >15%/20% for large caps/midcaps, respectively, with high conviction;
Buy: >10%/15% for large caps/midcaps, respectively;
Hold: Up to +/-10%;
Sell: -10% or more;

Pankaj Pandey Head Research pankaj.pandey@icicisecurities.com

ICICIdirect.com Research Desk,


ICICI Securities Limited,
1st Floor, Akruti Trade Centre,
Road No 7, MIDC,
Andheri (East)
Mumbai 400 093
research@icicidirect.com

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We /I, Sachin Jain, CA, Vasant Lohiya, CA and Vishal Narnolia, MBA Research Analysts, authors and the names subscribed to this report, hereby certify that all of the views expressed in this research report
accurately reflect our views about the subject issuer(s) or securities. We also certify that no part of our compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or
Disclaimer
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