An underlying theme for the last few months has been progressive tightening in financial conditions. There are important channels of tightening and implications therein that one needs to be aware of:
1. With a substantial recent rise in US dollar and associated rise in emerging market (EM) risk premia, the environment for offshore financing has become extremely challenging. Presumably, this will curtail fund raising for all but the best rated entities.
2. liquidity conditions have been tightening rapidly. The first part of this was associated with the re-monetization phase of the system where ‘accustomed’ liquidity backdrop as reflected in very low rates on liability pricing started to get challenged, as the system started moving towards ‘normal’ liquidity levels. The next phase, which is underway, is associated with somewhat deficit current liquidity conditions, but extreme uncertainty with respect to forward liquidity. As pointed out before, unless RBI acts proactively, core system liquidity deficit will probably be in excess of 2% of net demand and time liabilities (NDTL) of banks by March.
3. Partly as a result of liquidity uncertainty and partly owing to revised rate expectations post recent INR depreciation, term spreads in the market have risen rapidly. At the time of writing, a 2 year AAA PSU bond is dealing at close to 9%. As discussed before, the swap curve is pricing in more than 3 back to back rate hikes from here. Primary issuances in the corporate bond market have slowed substantially versus previous years.
4. In an already tight environment, recent credit episodes may have further heightened liquidity preference of the market. In such a situation, the risk is for credit spreads to further blow out. Refinancing pressures may quickly mount and balance sheet growths may have to be rapidly curtailed.
Implications:
The objective of monetary policy is not to set the overnight rate alone but, more generally, influence overall financial conditions to achieve a particular growth / inflation objective. In the current context, India’s financial conditions are already rapidly tightening and actually call for more policy predictability than otherwise. Put another way, the objective of financial stability (which is the ultimate goal of any monetary policy framework, even if the proximate goal may be CPI targeting) may be in far greater threat from a rapidly tightening financing environment than from minor potential overshoots in either CPI or the value of the currency. Given this, in our view, one should expect less and not more hawkish outcomes of policy relative to expectations. Hence, it is very likely that market is overpricing future policy hawkishness (on liquidity and rates) especially in light of recent events. As before, investor preference should run from sovereign, to AAA, to lower rated. This is an exceptionally challenging environment for lower rated / high yield strategies, should this continued tightening of financial conditions not get arrested. This also makes for a very non-conducive growth environment and we fully expect growth to be impacted a quarter or so down the line.
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