Toward shorter-maturity funds

Central bankers have to wrestle with a dilemma which is termed the impossible trinity. It means that of the three variables inflation...

Central bankers have to wrestle with a dilemma which is termed the impossible trinity. It means that of the three variables inflation,interest rate and exchange rate a central bank can at any given point control two,but not all the three,variables. If inflation is to be controlled,interest rates must be tightened. But higher interest rates attract more capital inflows,which causes the local currency to appreciate. A higher currency affects a nations export competitiveness.

In its recent monetary and credit policy,the Reserve Bank of India RBI hiked the cash reserve ratio CRR by 75 basis points. Now this was a measure meant to suck liquidity out from the system. However,if it results in higher capital inflows,it will not only cause the rupee to appreciate but will also infuse more liquidity back into the system as all those who get dollars into India will convert them into rupees and start investing them in the Indian equities and real estate market.

So by hiking CRR to control inflation,RBI may have created a new problem for itself that of more inflows and an appreciated local currency.

Managing capital inflows

The focus will now shift to controlling capital inflows. In RBIs first ever teleconference,Governor Subbarao said: All emerging market economies now believe that capital inflows will increase in the months ahead. If that happens,based on Indias growth prospects it is possible that the inflows will be much beyond our current account deficit. In the medium-term,it is our objective that India expands its absorptive capacity to absorb the capital flows. But in the short-term should there be flows largely in excess of our current account deficit8230; we may have to take some measures towards capital control.

Rupee likely to appreciate

What and how strong the capital control measures will be,we will have to wait and watch. But it is important to note that the rupee has already hit a weekly high on February 3 due to a combination of factors. Analysts expect it to hit the Rs 46/USD level in a few days. Wells Fargo has upped its rupee forecast to Rs 43.5 in the next 12 months and has given a buy recommendation. This is approximately 5.43 per cent higher than the Rs 46/USD level.

Fiscal consolidation is the key

One of the key assumptions of the monetary policy was that the government will resort to fiscal consolidation. Subbarao said: The reversal of monetary accommodation cannot be effective unless there is also a roll back of government borrowing.

Our bloated fiscal deficit is the biggest concern now. Higher fiscal deficit means higher bond yields and higher cost of borrowing for corporates. But here again there is a dilemma. If the spending binge is not controlled,the runaway fiscal deficit will clearly create problems for the economy. At the same time,if spending is reined in it may hamper the economic recovery,which is still at a nascent stage,and about which the RBI Governor himself is not sure! RBI raised its economic growth forecast to 7.5 per cent,but at the same time the Governor said that he is not sure of the economic recovery being for real and that it is yet to fully take hold. Thus it is most likely that the government will adopt a calibrated approach to exiting the fiscal stimulus.

The macro picture

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So what are the conditions we are in right now? A high fiscal deficit,the likelihood of huge capital inflows,a hawkish central bank,fiscal stimulus that needs to be withdrawn gradually,and a nascent economic recovery. It is expected that the budget will have some big bang announcements about PSU divestment,while at the same time serious measures will be taken to reduce the deficit. A crucial but unpredictable variable in the entire situation is the monsoon: if it turns out to be poor this year as well,it will have negative repercussions for the stock markets.

Bond yields have already risen in the aftermath of the credit policy. Many experts believe that the 10-year treasury bond yield will rise to the 8-8.5 per cent level over the next one year.

What does this mean for you

All this means that investment in long-term bonds and bond funds is out of question. Stick to liquid schemes of mutual funds or floating-rate bond funds. Some tax arbitrage is available at present,but moves are afoot to remove these. Purely from a pre-tax returns strategy,one should remain in bond funds with as short-term a maturity as possible.

If you have invested in income or gilt funds and are sitting on a loss,ask your advisor about the expected strategy of the fund house. If the fund house intends to reduce the average maturity of the funds,you may remain invested in them. But if the fund house has no plan to do so,a better option would be to book losses and shift to bond funds with short average maturity.

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In equities,public-sector companies remain the flavour of the season. Long-term investors need not worry about annual developments which does not mean they need not be aware of them! as all they need to do is continue their SIPs systematic investment plan for 10 years or even more in an index fund.

The monsoon clearly remains the joker in the pack. Keep an eye on developments on this front.

The author is a professional financial trainer and is proprietor of Nagpurbased Money Bee Institute.

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