By Lakshmi Iyer, Senior EVP, CIO-Debt & Head-Products, Kotak Mahindra Bank
India predominantly is a bank based economy, implying that most Indians are familiar with banking products as traditional mode of investments. Hence, it is natural to assume that most Indians have some form of debt market owner ship through such products liked bank fixed deposits, post office savings, NSC etc. There is lesser awareness with respect to mutual funds offering debt schemes to cater to varied needs to the Indian populace. In that, key to note is that such mutual fund offerings do tend to be linked to the interest rate cycle prevalent in the economy at a given time. Topical therefore is to bring in the recent de-monetisation introduced by the Govt of India and its potential impact it could have on the bond markets.
De-monetisation undertaken by the Indian government is a radical break from the past. By any measure of assessment, it has imposed a high cost on holding cash and has incentivised banking transaction. Of around INR 14 lakh crore that is held in old Rs 500/- and Rs 1000/- notes, it is estimated that already around 5 lakh crore has flowed into banking system as people scramble to exchange their notes, and/or deposit their money in the banks.
It is possible that in the near term, the cash crunch may cause reduction in general consumption. But in the similar period, the inflow of funds into the banking system is expected to put downward pressure on interest rates. Already banks are slashing their deposit rates, yet the surge of inflows doesn’t seem to abate. These funds invariably will find allocation intobond market as one of the alternatives in absence of the credit offtake. Thus, interest rates in the economy have scope to ease further from the current levels.
On the other hand, the decline in cash based consumption, could lead to moderation in demand in near term. This could mellow down some pressure on inflation, providing further headroom for benchmark repos rate reduction for RBI in the months to come. More importantly, it is estimated that a sizeable portion of cash may choose not to reveal itself to the banking system. This portion of cash would likely get extinguished. Such extinguished notes will act as reduction in liability in RBI’s balance sheet. This will make a sizeable proportion of funds available for RBI to either pay-out to the government, or to pay-out towards the existing liabilities.
So from the debt management perspective, the de-monetisation has created a strong bullish overhang within the system that will begin to manifest itself in the near to medium term. Thus, from the debt fund perspective, investors can look at maintaining their allocation in the duration funds and also allocate at price dips (spike in yields), if the opportunity presents itself.
We believe that the interest rates in the system may come down sooner and with a surprise, making a circumspect investor lose out on the bulk of the opportunity. Hence key message to the investor is to stay invested and/or look to increase overall portfolio duration.
The additional perspective is that the decline in cash based consumption is expected to hit demand in sectors (in the short to medium term) where cash transaction in value and volume are high. As a consequence, sectors such as real estate, construction materials, consumer discretionary, gems &jewellery etc could face some head winds. This may also have spill over effect on other dependent sectors. As a consequence, we believe that we may see moderation in these sectors and in the GDP in this, and in the next quarter
However, as the decline in currency circulation leads to reduction in prices, and as the interest rates decline, we may witness a triad of affordable capital, affordable raw materials (land & machinery) and already cheap labour. This creates a strong ground for genuine entrepreneurship led growth in the medium to long term.Hence the softening impact on GDP,would likely be a temporary phenomenon. In the interim period, we may see volatility in the equity market due to disinflationary effect of de-monetisation, the possible rate hike by US Fed, and due to the looming Italian debt crisis.
For an equity investor, it is advised to invest gradually in the market in a staggered manner. This will help them average the cost of investment and also tide over the short term volatility in this period while also position themselves for long term growth.Investors unwilling to take a high exposure in equities may invest in balance fund which typically has equity exposure to the extent of around 70 percent of the portfolio and the remainder into debt instruments
In the closing, we are transitioning through a very critical phase in modern India’s economic history. The de-monetisation, and the ability of the population to transition to a relatively cashless payment systems (as a fallout of de-monetisation) will determine the pace, the direction, and the extent of growth the Indian economy will take.