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Implications of Credit Policy

While the rate cuts have given a further boost to the surfeit of liquidity, the government is expected to be the biggest beneficiary with cheaper borrowing cost in the absence of little credit offtake from the industry

1. 50 basis points cut in bank rate to 6.5 per cent
Implication: Will trigger a drop in banks' and institutions' lending rates and bring down the cost of borrowing. Would put spreads under pressure if not followed with a similar cut in deposit rates. However, whether it will ignite credit offtake and economy revival is the million-dollar question.

2. CRR Slashed by 200 basis points
Implication: Cash Reserve Ratio will cut in two phases – first to 5.75 per cent from the current 7.5 per cent on November 3 and then to 5.5 per cent on December 29. The reduction will pump Rs 8,000 crore to the system and only buoy the current surfeit of liquidity. However, with the RBI removing most exemptions and adding FCNR and other deposits for the calculation of CRR, the actual reduction is only 0.8 per cent. With hardly any credit pickup, the additional money will further fuel rally in the bond markets and help accommodate government's higher than targeted borrowing programme.

3. Interest rate on CRR balances increased to the level of bank rate at 6.5 per cent
Implication: The move will benefit banks and perk their income. It is expected that higher interest income will roughly add Rs 1000 crore to banks' kitty with State Bank of India being the biggest beneficiary.

4. The RBI has asked banks for a variable interest rate system on long term deposits
Implication: The move comes after the central bank recently asked the government to adopt a flexible approach and provide market-determined yields on small-scale savings. If the government and banks are able to do away with the fixed interest rate regime, it will mean that returns are in sync with market yields, which will be surely more realistic. Thus, interest rates will not be devoid of reality but move in line with business cycles and inflation. And remember, it doesn't mean that interest rates will only go down – they can also go up. A variable interest rate structure will also guard banks' spread, which normally refrain from aggressively cutting deposit rates since a large chunk of fixed income group depends on bank deposits. The ball is also now in the government's court to reduce rates on small savings and initiate a sustained drop in interest rates.

What Should You Do?
The cut in both bank rate and the quantum of reduction in CRR has taken the bond markets by surprise. The net asset values of bond and gilt funds have shown an appreciation with a jump in underlying bond prices. The yield on the 10-year benchmark fell by 15 basis points and closed below the 9 per cent barrier (8.96%) for the first time. However, a runaway rally is unlikely, both because of structural bottlenecks and RBI's unwillingness (seen earlier) to allow a free fall in yields in isolation. Thus, any sharp dips could see auctions and OMOs to correct yield levels. That said, the downside is also limited in the current scenario with RBI committed to soft interest rates unless of course there is an event risk (like escalation of war in Afghanistan). Thus, the coming days could see higher volatility in bond prices as yields move in a cordon.
While the rate cuts have triggered euphoria, investors will do well to avoid losing sight of their objectives in expectation of some quick returns. Event risks still continue to linger with uncertainty on external front. Thus, investors should just stick to their time horizon and do not attempt to time the market. Invest in bond or gilt fund (9-months and beyond) only for the long-term to ride out the intermittent volatility. Conversely, invest in a cash fund if you need your capital just a few days or weeks down the line.