The Reserve Bank of India in its monetary policy review surprised the markets with a 50 bps rate cut. A few expectation stood at status quo based on the technical indicators, whereas a few expressed their views as a 25 bps cut. Dr. Rajan ultimately decided to cut rates by 50 bps taking the advantage of the appropriate levels of room given by the lower inflation. The markets and the corporates have welcomed the rate cut. Although, there has been a certain level of transmission loss so far but RBI is hoping for a complete transmission with time. RBI in 2015, has already scored a century with its total of 125 bps rate cut to boost the economy, but the govt seems to struggle to achieve the same. Apart from the surprise rate cut, there was a lot more in this policy on the reforms side of it. In this article, we will take a look at the reforms other than the 50 bps repo cut and discuss in brief about the probable contribution of rate cuts in boosting equity returns.
With almost no signs of reforms from the fiscal policy stance in the form of GST bill passage, RBI has decided to take the initiative in driving the investment. RBI in its recent policy statement has given certain decision, which are expected to drive the investment in India.
Following are the reforms:
- Guidelines on Marginal Cost of Funding have been given to banks. RBI has initiated the process of reducing the transmission losses. The banks have been asked to shift from the current system of Average Cost of Funding to a more advanced approach of Marginal Cost of Funding. It is expected to boost the monetary transmission mechanism and pass on the benefits to the economy in the shortest possible time.
- RBI has also asked the MCA (Ministry of Corporate Affairs) to create a road map for convergence of Indian Accounting Standards with the IFRS standards. The move was taken in view of resolving discrepancies in the analysis of companies and to be at par with the international standards for normalization.
- The real estate sector has been holding on inventories worth Rs. 70000 Crore from the past year, due to the fall in the prices. RBi had asked the realtors to clear the inventories at lower cost since the prices are supposed to be market driven. The response was extremely lukewarm in nature. Thus, RBI has now initiated the move through its monetary tools. It has given banks the liberty to reduce the risk weights on the housing loans, which will bring down their costs and ultimately the cost to the customers. This is an attempt of RBI to make houses more affordable by giving them lower rates of interest. The rates of interest for housing is supposed to hover in the range of 9.5-10%.
- With the chances of fed hiking rates in the early 2016 or so, liquidity might face certain pressure in the country. RBI has hence decided to reduce the SLR requirements by 25 bps each quarter till march 2017 to sustain the liquidity crunch that might arise. SLR requirements are supposed to come down to 20% from the current levels of 21.5% (6 Tranches of 25 bps reduction in each quarter).
- With a view to making identification of banknotes easier for visually challenged persons, the process for introduction of additional identification marks in banknotes in the form of angular bleed lines has been initiated and is being introduced in the denominations of Rs. 100, Rs.500 and Rs. 1000 as raised lines on both the left and right sides of the obverse of the banknote: 4 lines in 100, 5 lines in 500 and 6 lines in 1000. Furthermore, the size of the existing identification mark in these denominations is also being increased by 50 per cent to facilitate better identification.
- Additionally, the investment by FPI route into the debt markets has been eased to boost investments.
Lets discuss a bit about the markets, will the rate cut boost the returns from the equities and if yes, then what time horizon it will require.
Historical evidence suggests that, with interest rates reducing, companies tend to save on their interest cost, leading to higher profits, high job creation and more demand boosting the revenue growth. The effects of the same, will be seen as increase in corporate earnings and attractive valuation. Generally, whenever rate cuts have led to a meaningful demand push, the corporate earnings and PE ratio have improved. The image below indicates the relationship between the rate cuts and the valuation as well as the corporate earnings.
Currently, the state of the economy looks extremely feeble in nature, although it is the fastest growing economy. Data till date, indicates that, if the repo is at or above 8% mark, valuation take a hit whereas if they are around 6%, valuation look up. The valuations are supposed to improve according to the data, but this time the global economies are under intense slowdown pressure. The effects of these rate cuts on the market will be extremely short – lived. I believe, supposing that the transmission improves and interest cost come down, rate cut aid alone can almost never make up for the absence of the household demands and corporate earnings. Although, the current year and the first half of the year 2016 does not seem overwhelming, rate sensitive industries will definitely stand to gain in the current fiscal. Industries like banks, capital good, constructions, auto ancillary etc will be the key beneficiaries. The investments in the equities as of now might not reap you extraordinary returns but by FY 2017, the returns will be substantial in numbers. My recommendation would be stay invested and keep looking for potential value stocks.
To conclude, the inverse correlation between the interest rates and the PE and the valuations usually takes time to unfold. Although, banks have already reduced their interest rates by about 70 bps on an average against a 125 bps rate cut by the RBI. We can only hope for a much better and an effective transmission. I expect the interest rates to come down by another 50 bps in the case of banks in the near future, which might reduce the interest cost for the corporates. Given the low base of corporate earnings in FY 2015, performance should ideally show some improvement on a y-o-y basis from the Dec Quarter. Going ahead, a genuine improvement is unlikely before FY 2017 and only then will we witness some meaningful gains. Short term markets are likely to be bullish, medium term are likely to be neutral, but with the series of rate cuts this year, long-term indications are undoubtedly bullish in nature with the corporate earnings showing improvements. The commodity prices are also expected to be dented in the near future, which might add to the betterment of the economic indicators. Although, the RBI has done its bit in boosting the growth and investment, rest depends completely on the domestic demand pickup in the near future and the Govt reforms.
Thank you. 🙂