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Repo Rate Up 25 Basis Points

While bank rate has been kept unchanged at 6 per cent, repo rate is up 25 basis points to 4.75 per cent. The hike is a bad news for debt mutual funds

In the Mid-term Review of Annual Policy Statement for the financial year 2004-05 announced today, the Reserve Bank of India has hiked the repo rate by 25 basis points to 4.75 per cent. However, the bank rate has been kept unchanged at 6 per cent.

As a result of this repo rate hike, bond yields have already started to move up leading to fall in bond prices and will subsequently hurt most debt mutual funds' categories. Those apart, the GDP growth projection for 2004-05 has been lowered to 6.0-6.5 per cent from 6.5-7.0 per cent earlier and the inflation forecast revised upward to 6.5 per cent as against 5 per cent projected earlier.

Highlights of the Policy Review:

1. Bank Rate: Kept unchanged at 6 per cent.

2. Repo Rate: Raised by 25 basis points to 4.75 per cent from 4.50 per cent effective from October 27, 2004. The reverse repo rate will continue to be linked to the repo rate, as at present. However, the spread between the repo rate and the reverse repo rate is reduced by 25 basis points from 150 basis points to 125 basis points. Accordingly, the fixed reverse repo rate under LAF will continue to remain at 6.0 per cent.

As already announced, the RBI has proposed to switchover the international usage of the terms 'repo' and 'reverse repo' effective October 29, 2004. With such a switchover, the fixed reverse repo rate will be 4.75 per cent and the repo rate will be available with a spread of 125 basis points at 6 per cent.

3. Revised Liquidity Adjustment Facility (LAF): With a view to further enhance the effectiveness of LAF and to facilitate liquidity management in a flexible manner, the RBI has proposed that LAF scheme would be operated with overnight fixed rate repo and reverse repo with effect from November 1, 2004. Accordingly, auctions of seven-day and 14-day repo (reverse repo by international parlance) would stand discontinued from November 1, 2004.

4. Forecast for Economic Growth Lowered: GDP growth projection for 2004-05 has been placed in the range of 6-6.5 per cent as against the earlier expectation of 6.5-7.0 per cent.

5. Inflation Projection Hiked: The point-to-point inflation rate based on Wholesale Price Index (WPI) for the year 2004-05 is projected at around 6.5 per cent for policy purposes as against 5 per cent projected earlier.

6. Reduction of Tenor of Domestic Term Deposits: In order to provide uniformity in the tenor of term deposits, it is proposed that banks, at their discretion, can reduce the minimum tenor of retail domestic term deposits (under Rs 15 lakh) from 15 days to 7 days.

7. Commercial Paper: With a view to develop the commercial paper (CP) market further, the minimum maturity period of CP has been reduced from 15 to seven days with immediate effect.

8. Market Stabilisation Scheme (MSS): The ceiling on the outstanding obligation of the government under the MSS has been raised from Rs 60,000 to Rs 80,000 crore, while the threshold level for further review of the ceiling has been placed at Rs 70,000 crore. Treasury Bills and dated securities worth Rs 54,146 crore were issued under the MSS up to October 21, 2004, out of which dated securities amounted for Rs 25,000 crore.

Implications for Debt Fund Investors

The hike in repo rate is an indication that we are no longer in the soft interest rate environment. The bond market yields have already started to inch upward leading to fall in bond prices and will subsequently hurt majority of debt mutual fund categories. After the policy announcement, the yield on the 10-year benchmark (GOI 2014, 7.37%) was trading at 6.93 per cent – up 22 basis points at 2.22 pm on Tuesday over Monday's close of 6.71 per cent. Hence, the NAVs of all income funds will fall today depending on the average maturity of the fund. Funds with higher maturity will be the worst affected.

On the other hand, the repo rate hike will increase the returns of cash funds. How? As repo rate acts as a floor for the short-term rates, a hike in repo rate will also increase call rates, which would eventually elevate the returns from cash funds that invest in the call and money market.

Generally, rising interest rates are bad but once rates have risen and stabilised, then the higher interest rates are generally good for investors as your money would now grow at a higher rate. But if oil prices and inflation continue to remain high, we are unlikely to witness stability in the Indian debt market as more such hike could be in the offing.

Hence, consider investment in income funds only if your investment horizon is long enough of say 2 to 3 years. Otherwise, staying with floating rate funds or short-term funds will be a better option.