It’s not an enviable phase at start of H2/FY21 after complete washout of H1 from Covid–19 triggered lockdown. The newly constituted MPC set to begin on 29th September is now deferred. While it’s not an ordinary course to postpone a scheduled MPC meeting, there’s nothing to get worried when expectations was reiteration of August policy review in the absence of clarity of Q2/FY21 economic and Covid- moratorium & restructuring data.
Conflicts between inflation targeting and supporting growth:
MPC is in cross roads on inflation targeting having allowed headline CPI to stay sticky over tolerance zone of 2-6% since end of FY20 with compulsion to take supporting stance on growth when Q1/FY21 GDP contraction by over 20%. Whether blame it (stickiness of CPI over 6%) on supply-side output squeeze or higher cost of logistics & transport from lockdown, can’t ignore impact from sharp decline in operating policy rate from 6.5% to 3.35% in 2019-mid 2020, and more so from widening LAF corridor from 25 to 65 bps, post shifting of system liquidity from marginal deficit to excessive surplus mode.
Now that, the current dynamics (elevated inflation and contracting growth) is there to stay till end of FY21, MPC is not expected to turn neutral from current accommodative stance. On the other hand, it would be counter productive to cut policy rates in support of growth putting aside upside risk on inflation. So, it’s no-brainer decision to remain status-quo on policy rates, having already cut CRR to 3% and contradictory move by increase of HTM limit to 22% from 19.5% (against SLR of 18%), which highlights the existence and management of conflicts & complexities.
Another point of view is squeeze of LAF Corridor from 65 bps to 40 bps. The purpose of increasing the spread from 25 bps to 65 bps was to push banks into lending post conversion of system liquidity from marginally deficit to excessively surplus. But, this measure has done more harm than good for the system as ₹5-8 Trillion gets back to RBI at 3.35% pushing the T-Bill yield curve sharply down at 3.25-3.65%, lower half of LAF Corridor 3.35-4%. So, it makes sense to squeeze the LAF corridor to 3.35-3.75% in alignment with short term yields. It should also be noted that Banks pay spread of 2.65% (losing 6% YTM on OMOs and earning 3.35% in return) and receive 2% against Repo rate of 4% losing 65 bps spread. This is the major reason for lack of appetite on RBI auctions – regular/OMO/OT, which builds logic to cut Repo rate squeezing LAF corridor. It makes sense when operating policy will any way get shifted from Reverse Repo to Repo sooner and not later than end of Q3/FY21. So, expectation on policy rates is divided between status-quo or 25-40 bps rate cut in Repo rate to squeeze LAF corridor at 3.35-3.60/3.75%. For this, MPC should have greater comfort on headline CPI trend down and sustainability at lower end of tolerance zone at 2.50-2.75% given the unwritten formula of Repo rate = CPI + 1-1.25%
What’s beyond MPC mandate? Eager to know FY21 estimate on GDP growth and extent of policy engagement to support Finance Ministry
Given the unanimity that it’s appropriate to stay in favour of supporting growth in Covid-era, stakeholders will be eager to know RBI’s estimate on FY21 GDP contraction, when Finance Ministry is yet to come out with RE of FY21 taking into account lockdown impact on output and fiscal deficit. Now, stakeholders are left to go by estimates of economists & analysts, which gets revised on monthly basis. RBI estimate on FY21 GDP and CPI will provide clarity on alignment between nominal growth (contraction) and marginal cost of funds to get comfort & grip on the way forward on monetary dynamics.
Another major concern for RBI is from the role of debt manager of GOI market borrowing program, which builds conflict of interest, playing between the Government, the largest single borrower in the system and the banking sector, largest group of investors absorbing GOI/SDL bond issuances. H1 borrowing of over ₹6 Trillion has been smooth without disruption retaining 10Y yield at 5.75-6.25% and short term rates in trend down mode at 3.25-4.25%. Intent of RBI is to get H2/FY21 borrowing smooth retaining rate & yield stability at these levels, which is not difficult to achieve in the absence of credit demand. Banks also have additional comfort from higher HTM limit to support 10Y yield at 6.10-6.25%
RBI’s efforts to push credit flow to neglected sectors has yielded results
It’s relief for RBI that credit flows to NBFCs/MSMEs have improved significantly, lenders taking advantage of subsidised cost of liquidity from TLTRO counter, funding through SIDBI/NHB/NABARD and backstop credit underwriting schemes of the Government.
What Next? There’s no clarity as yet on extent of impact on NPAs and CAR from restructuring scheme of Covid-19 moratorium portfolio. When GDP & output is in contraction mode, demand for credit is expected to be low for rest of FY21 with top line credit growth largely from retention of payment of principal + interest (of 1/3/2020-31/3/2021) in the books, inclusive of higher exposure on account of restructuring of loans. It’s blessing in disguise for RBI that in the absence of credit demand, excess liquidity could easily be diverted into GOI debt without liquidity & yield disruption. RBI’s mandate to ensure adequate credit flow to economic sensitive sectors at affordable rate can be shelved till April 2021 policy review. Banks excess SLR limit of over ₹5 Trillion (4% of NDTL) is the trump card for RBI for smooth sailing of GOI borrowing. What about beyond int FY22?
In conclusion, what’s the expectation from RBI and impact on financial markets? Keep it simple and focus on price stability till real economy shifts from contraction to growth mode
Policy rates – status quo on rates & CRR/SLR) or Repo rate cut by 25-40 bps
LAF corridor at 3.35-4% is abnormal when Banks will hold 4% of excess SLR in HTM (over ₹5 Trillion) and there would be need to release this liquidity from Repo counter at spread of 2.50-2.65% between 10Y yield & Repo rate. As of now beneficiaries of dovish monetary stance are GOI (from lower yield) and AAA/AA (lower credit spread) and losers being banks & depositors. So, expectation is mixed between 25-40 bps cut in Repo rate leaving Reverse Repo rate unchanged to squeeze spread between Reverse Repo rate and Repo/MSF/Bank rate or keep policy rates unchanged. Having done enough on liquidity releasing permanent liquidity of ₹1.25 Trillion through CRR cut and an extraordinary position of elevated HTM at 22% (diverting ₹5 Trillion from banks to GOI), there’s nothing left to be done to liquidity, other than adding liquidity to arrest ₹ appreciation and through OMOs to arrest spike in long term Gilt yields. Advantage for RBI is the comfort that H2/FY21 borrowing of over ₹6 Trillion would be managed from system liquidity without significant yield disruption without resorting to deficit monetisation.
What’s impact on India financial markets?
Money market will retain price stability amidst liquidity overhang. T-Bill yield curve will trend up from 3.35-3.65% to 3.65-4% on assumption that weighted average call money rate in H2/FY21 may not be beyond 3.50-3.65%. This assumption holds good when (a) LAF remains unchanged at 3.35-4% and operating rate at lower end in Q3/FY21 and thereafter to upper end in Q4/FY21 (b) LAF corridor squeezed at 3.35-3.65/3.75% that would push excess liquidity into HTM triggering shift of operating policy rate from Reverse Repo to Repo rate before end of Q3/FY21. This scenario is good for GOI & AAA/AA borrowers and relatively better for Banks & depositors.
What about 10Y benchmark yield? If seen against H1/FY21 range at 5.75-6.25% and now at 6.05-6.10%, RBI should be fine to administer H2/FY21 range at 6-6.25%, which is not bad at all given the beyond expectation GOI borrowing for FY21. What if private demand picks up, diverting flow from GOI bonds to credit & non-SLR portfolio? This is the risk factor in play that brings the risk-off & duration-cut urge at 5.85-6% keeping 6.20-6.35% in radar with better comfort that 6.35-6.50% would be excessive in FY21 when credit demand is muted. Risk also remains from external dynamics in the event of US 10Y yield spike into 0.85-1%, which is low given the FED comfort of retaining zero interest rate policy till 2023.
Interest rate dynamics will continue to stay ₹ supportive with elevated yield spread across 1-10 years (current range at 4-5.5%) which is good to pull-in carry-trade flows, both on debt & equity. It’s outlook positive on FDI flows from fresh investments and Indian corporations diluting equity with foreign investors, Reliance & others have showed the way. For rest of FY21, don’t see major risk of big-time FPI pullout. All taken, RBI would continue to be in the enviable position of buying USD/INR to arrest ₹ appreciation allowing orderly depreciation at 72.50/73.50-76/77. It suits when RBI is fine to expand USD reserves (steadily moving upwards of $0.5 Trillion) and adding to system liquidity.
It’s impact neutral for equity markets given that RBI doesn’t like creation of asset bubbles (from overheated valuation in contrast to performance of real economy and corporate earnings) from low cost liquidity overhang, to be used primarily for subscription to GOI bonds and credit deployment. Having said this, market friendly LAF corridor and extended phase of accommodative monetary stance will stay supportive to equity market. So, from monetary policy perspective, it’s more of non-event as price & valuation continue to be dependent on external cues (in alignment with US equities) and impact of Covid-19 on earnings and weight on the banking sector.
It’s business as usual despite low visibility on the timing of Covid-19 going off radar and the impact that’s left behind on the lives & livelihood and on the economy & exchequer. It’s another 3-6 months to get better visibility & clarity on as-is position and turnaround momentum.
Moses Harding
