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Jalanspeak Fails To Enthuse

Cash Reserve Ratio cut, Bank Rate static, restricted entry in call markets and floating interest rates. The result: the BSE Sensex fell by 71 points and 10-year benchmark yield went up from 7.28% to 7.31%. Basically, a rather unexciting policy which fell short of investor expectations. We tell you why.

The slack season monetary & credit policy for 2002-03, unveiled by the Reserve Bank of India Guv, Bimal Jalan, has been rather so-so. After the central bank put off the bank rate cut, bank scrips fell, followed by the Sensex (down 71 points). SBI plunged 2.81%, Bank of Baroda slipped 2.66% and Bank of India was down 1.92%. Global Trust Bank , HDFC Bank (-2.14%) and ICICI Bank (-2.54%) slipped too. Also, the yield on the 10-year benchmark firmed up from 7.28% to 7.31%. Even governor Jalan's announcement that the bank rate may be cut by 50 basis points in the future failed to enthuse the markets. We now present the key highlights of the policy.

Reduction in cash reserve ratio from 5.5% to 5% effective June 15, 2002
Implication: The reduction is in line with the central bank's target of bringing down CRR to 3%. This means more money at the disposal of banks, which may find its way into gilt trading if the credit offtake stays low. However, this is unlikely to set off a bond rally similar to the one seen in 2001, as the yields are at their nadir. In other words, it will be less profitable for banks to make money from gilt trading.

Bank rate left untouched at 6.5%, but RBI may cut the same by 50 basis points if the liquidity and credit situation warrants.
Implication: It implies that the apex bank is comfortable with the prevailing interest rate regime. Indian rates are in tune with the current global rates -- which have rather gone up -- in the past few months. In theory though, a fall in the bank rate means banks can lower the lending rates, which, in turn, can lead to credit offtake. But the reality is different. Despite slashing the bank rate by 50 basis points each on three occasions since February 2001, the banks slacked on reducing the lending rates. Consequently, credit offtake increased by a mere 12% till March 22, 2002 as against a 14.8% increase during the corresponding period in 2000-01. However, RBI has reiterated that if the credit demand does not pick up, bank rate may come down by 50 basis points.

RBI will encourage flexible interest rates on all new deposits, with 6-monthly reset conditions. But fixed rate option will also be offered to depositors.
Implication: This is a step in the direction of market-determined interest rates. Prior to Budget, banks shied away from introducing a variable interest rate structure for deposits to avoid losing customers to small-savings schemes In Budget 2002-03, the finance ministry had linked interest on small savings to the average GOI yields. For an investor it means that as against the present fixed interest income from deposits, the same will increase with a rise in the overall interest rates and vice-versa. This will allow banks to align lending rates with their borrowing costs.

RBI has directed banks to review the spread over PLR and reduce the same if they become unreasonably high. That apart, banks will have to make public the maximum spread over PLR. The savings rate has been kept untouched at 4%.
Implication: With the cost of deposits remaining the same, this move translates into reduced margins for banks. Indirectly, the RBI has provided a room for lowering lending rates, and, hence, encourages corporate borrowings. If it is high interest rates that have deterred corporates from borrowing, this, in the long run, could provide the much-needed fodder for economic revival.

Banks lending in call/notice money will not exceed 25% of the net-owned funds as on the last day of the previous financial year. Also, banks can borrow upto 100% of the net-owned funds or 2% of the aggregate deposits, whichever is higher.
Implication: This will limit the participation of banks in the call money market to meeting reserve requirements. With increasing deposit base and no simultaneous credit offtake, banks have been funding their gilt exposure through call money markets. Lest the excessive dependence on the short-term money result in asset-liability mismatch for banks, this ceiling has been introduced.

What Should You Do?
The bond markets had expected a 50-basis point cut both in the bank rate as well as CRR. With half-expectations being met, it may not be wrong to expect a correction in the bond prices, and, hence, fluctuations in the returns from bond and gilt funds. At the same time, RBI may reduce the bank rate by 50 basis points, which could be the next trigger for bond yields to fall. But a further fall in yields may be met with aggressive OMO auction from the central bank, and a correction thereof.

With interest rates moving towards stability and the emergence of flexible interest rate regime, investors should look forward to average returns from bond funds.