Over the past six months, RBI has focused more on pushing up liquidity rather than giving rate signals
The credit policy or monetary policy is announced by the RBI every two months. The purpose of the policy is to give a picture about the inflation in the economy, the likely path of interest rates and the liquidity in the system. Additionally, the policy also reviews the global economy and gives hints on how the Indian economy could perform in the near future.
Riaz Ahmed, a middle-aged drilling engineer in an MNC, wants to understand how the monetary policy will actually impact him. As an engineer, he has a perfect understanding about the mechanics of drilling but is hardly aware of economics.
He has, however, created a small portfolio of equities, bonds and mutual funds based on advice from his broker and his friends.
But he is now keen to understand how the monetary policy will impact his portfolio and his personal finances. It is essential for Riaz to understand 5 key implications of a credit policy
How will the credit policy impact household finances?
The one factor that really impacts a normal household is the inflation number. Typically, the inflation shows the extent of price rise in the economy. A high inflation is considered to be negative for households and a low inflation is considered to be positive.
Within the ambit of inflation, it is food inflation that matters the most. If the credit policy hints at higher food inflation, it is likely to hit the household budgets hardest. Inflation also has implications for interest rates as a lower inflation will spur the RBI to cut interest lower.
What does credit policy mean for interest rates?
Riaz is also keen to understand the interplay of interest rates and credit policy. It needs to be remembered that the credit policy not only signals the direction of interest rates but also actually sets higher or lower interest rates by re-setting the repo accordingly.
This is important for a variety of reasons. For a country like India lower interest rates means higher growth and higher economic activity. This means professionals like Riaz will see more economic activity which will directly impact their business.
Also a cut in interest rates will mean that the company he is working for can borrow money at lower rates and that is likely to positively impact the performance of his company and consequently his own career prospects too.
What does the credit mean for equity mutual funds?
Not many people are aware of the relationship between the credit policy announcement and the equity markets. There are 3 key links. Firstly, if the RBI signals lower rates then companies reduce their cost resulting in lower financial costs and higher net profits.
This obviously gets reflected in their stock price performance and in the NAV of mutual funds that hold these shares. Secondly, a lower rate signal has a multiplier impact on the economy as a whole as it spurs demand, encourages retail borrowing and also kick-starts economic activity.
All this gets reflected in stock prices and therefore on the NAVs of equity mutual funds. Lastly, stocks are valued in the market based on their future earnings.
Now, future earnings are discounted to the present to arrive at a value for the company. This discounting is based on the interest rates. When rates are cut, the discounting happens at a lower rate and therefore the valuation and the stock price moves up.
For mutual fund investors like Riaz it adds to their equity mutual fund wealth.
What does the credit policy mean for debt mutual funds?
A debt mutual fund is a mutual fund that invests in bonds issued by the government and by private corporates. There is a negative relation between interest rates and bond prices. That means, when interest rates are cut, the bond prices move up.
As a result, mutual funds that hold these bonds also see their NAV going up. Thus lower interest rate creates a wealth effect in debt mutual funds just as it creates a wealth effect in equity mutual funds.
For professionals like Riaz, this is great news because they can see their mutual fund portfolios creating wealth without too much effort and risk.
What does the credit policy mean for liquid funds?
Liquid funds are also a form of debt fund but they consist of short term debt. Liquid funds invest in treasury bills, commercial paper, certificates of deposit and other debt products with a maturity of less than one year.
While interest rates are long-term signals, these liquid funds are more influenced by liquidity signals given by the RBI. Normally short term rates go up when there is a shortage of liquidity in the money market and go down when there is sufficient liquidity.
Over the past six months, RBI has focused more on pushing up liquidity rather than giving rate signals. As a result, the surplus liquidity has brought down the short term rates resulting in price appreciation leading to higher NAVs for liquid funds.
While these liquid funds are normally preferred by companies and retired persons, they can be a profitable source for parking short term funds even for professionals like Riaz.
While the credit policy may sound like an esoteric statement in economics, it does have some real implications for everyone.
Here are a few basic cues…
>> Credit policy hinting at lower inflation is likely to be positive for household budgets
>> Lower interest rate hints are likely to positively benefit equities and equity mutual funds
>> Lower interest rate hints are also likely to result in NAV appreciation in debt mutual funds
>> Read the credit policy hints on liquidity. Comfortable liquidity is positive for short term liquid funds.
Credit policy basically impacts each one of us by the hints it provides on the subject of inflation, interest rates and liquidity. Each of them impacts your household budgets and your investment portfolio in a unique way.
Understanding these implications will go a long way in helping you make smarter investment and spending decisions.