The current macroeconomic predicament that India faces with regard to the depreciating rupee resembles, in many ways, the situation that arose in financial year 1997/98. At that time, with a high fiscal and current account deficit and sluggish GDP growth, the Reserve Bank of India (RBI) chose to prevent the rupee from falling by raising interest rates. While this helped to curb speculative activity, it culminated in higher yields on government securities (G-Sec) and corporate bonds. Subsequently, as the situation began to correct, G-Secrates eased and lending rates also came off as consumption slowed and growth weakened.
While the current situation and the RBI's reaction of raising rates has impacted the bond market all along the yield curve and dampened investor sentiment, a look at the past reveals that there is a big window of opportunity that can be tapped. Staying invested and increasing allocation in duration products at this juncture will likely result in gains once the situation stabilizes.
Macroeconomic shock - June 2013
In mid-June, the US Federal Reserve released a statement that it might start withdrawal of its stimulus measures later this year and end them entirely by mid-2014, because of the growing strength of its domestic economy. In response, India and other developing nations witnessed a large scale outflow of foreign institutional investor (FII) money. This was driven by international investors' speculation that such a policy would adversely impact liquidity in the global financial system.
RBI's interest rate defence
To combat the sharp down slide in the rupee, the RBI announced a series of measures that would raise interest rates. It hiked the marginal standing facility (MSF) rate by 200 basis points (bps) to 10.25 percent, while keeping the repo rate unchanged at 7.25 per cent. It also set the overall limit for access to liquidity adjustment facility (LAF) by each individual bank at 0.5% of its own net demand and time liabilities (NDTL) and asked banks to maintain a higher average cash reserve ratio (CRR), effective from 27 July. Lastly, the RBI conducted an open market operation (OMO) to sell gilts worth Rs.12,000 crore over and above the normal government borrowing for the current fiscal against which it could only raise around Rs.2,500 crore. These measures resulted in a spike in both short term and long term yields in the bond market with the one year certificate of deposits (CDs) and commercial papers (CPs) which were trading at 8.15 per cent and 8.76 per cent levels at the end of June rising to 10.33 per cent and 11.38 per cent respectively, by early August.
Market reaction
RBI's measures to stabilize the exchange rate caught market players completely off guard and yields on government and corporate bonds, money market rates and interest rate swap yields increased. Despite the RBI's assurance that these measures would be reversed once the situation was under control, they had a negative impact on the sentiments of investors in the fixed income segment. However, a look the situation in FY1998, which has many parallels to the one that prevails today, reveals that the current scenario presents a similar opportunity to long and short term debt product investors.
Revisiting 1998
In many ways, the macroeconomic situation and policy responses we face today are similar to those of 1998. In 1997/98, India was faced with a high current account deficit, slowing economic growth and a thrust on government spending, just as we do today. Taking the parallel further, due to excessive speculation on the rupee in 1998, India experienced sharp volatility in the foreign exchange market. At that time, just as it did this time too, the RBI used an interest rate defence to curb speculative activity and hiked interest rates. This resulted in higher yields on G-Sec and corporate bonds.
Lessons from the past
As a result of high interest rates in 1997/98, the consumption cycle slowed down considerably and inflation remained in check. Later, when the situation was brought under control, the RBI initiated follow-up action by issuing Resurgent India Bonds to stabilize the rupee and subsequently eased key interest rates. Consequently, bond yields fell and bond values increased. As in the past, once the current volatility in the rupee comes under control, the RBI is bound to return its focus to spurring economic growth by easing interest rates. This will result in a fall in yields and a rise in bond prices.
Window of Opportunity
The current account deficit is already experiencing some moderation as gold imports have begun to decline. As history repeats itself, it appears to be only a matter of time before interest rates come down and the G-Sec gains value. Against this backdrop, the current situation provides a brief opportunity to investors in all time segments of the fixed income market. Income and gilt funds offer an investment avenue for investors with a long term perspective while short maturity funds and fixed maturity plans (FMPs) offer scope for gain in the short to medium term. Liquid and ultra-short term funds are optimum investment avenues in the very short run as these would also benefit from the spike in short term yields.
The author is Managing Director & CEO, ICICI Prudential Mutual Fund
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