Market participants including ourselves have lately lamented the somewhat underwhelming response from the RBI to a rapid tightening in financial conditions evidenced in virtual freezing in even quality parts of the local financing market. However, while RBI may have lagged somewhat in speed it has certainly made up in magnitude with its announcements today. These come post an inter-period meeting of the monetary policy committee (MPC). Major announcements as under:
- Repo rate cut by 75 bps and reverse repo by 90 bps to 4.4% and 4% respectively. Thereby the corridor stands wider at 40 bps from 25 bps earlier. The upper band as denoted by the Marginal Standing Facility (MSF) continues at 25 bps over the repo rate. The decision to cut rates was 4 -2 in the MPC. Stance has been retained as accommodative.
- RBI will conduct Targeted Long Term Repo Operations (TLTROs) for up to 3 years amounting to a total of INR 1 lakh crores. The rate will be floating and linked to the policy rate. Liquidity availed under the scheme by banks has to be deployed in investment grade corporate bonds, commercial paper, and non-convertible debentures over and above the outstanding level of their investments in these bonds as on March 27, 2020. Banks shall be required to acquire up to 50% of their incremental holdings of eligible instruments from primary market issuances and the remaining 50% from the secondary market, including from mutual funds and non-banking finance companies. Investments made by banks under this facility will be classified as held to maturity (HTM) even in excess of 25% of total investment permitted to be included in the HTM portfolio. Exposures under this facility will also not be reckoned under the large exposure framework.
- Cash Reserve Ratio (CRR) cut by 1% to 3% effective the immediate fortnight for a period of 1 year. This will release INR 1.37 lakh crore liquidity into the system. Also daily CRR maintenance requirement reduced to 80% from 90% till June end.
- MSF limit raised from 2% of SLR to 3% of SLR effective immediately till end June. This will potentially provide access to another INR 1.37 lakh crores under the RBI window.
- In other measures various sorts of moratorium and dispensations on payment and recognitions have been provided without any impact required to be recognized on asset quality or the credit history of the beneficiary. The last tranche of capital conservation buffer has also been deferred. Also, banks’ access to the non-deliverable forward (NDF) market in currency has been partially allowed
Assessment
The RBI has now put to rest the concern that it was failing to appreciate the required pivot to emergency conditions. With these measures, it has addressed 3 of the 4 near term actions that we were expecting (https://www.idfcmf.com/article/1487). Thus an aggressive rate cut and an expansion of LTRO have been delivered whereas the RBI has been much more imaginative than we had been in addressing the stress in corporate and money markets. The problem thus far was that banks lately were not meaningfully channeling the abundant liquidity being provided to them by the central bank via its LTROs even into near term quality money market instruments. The design of the new program and the dispensations on fluctuation risk and exposure limits will hopefully restart banks’ appetite in quality money market and corporate bonds. Also the requirement to source 50% from the secondary market will substantially help liquidity for other market participants.
An important dimension that remains is for a very large open market operation (OMO) bond buying program. The format globally now is evolving around monetary expansion supporting fiscal policy and India needs to do the same. While the first response fiscal measures announced yesterday address the most susceptible citizens in a targeted way the government will soon also have to address the wider economy, given the substantial loss in output that is underway currently. However, there are already natural pressures on its finances and we already expect a 100 bps slippage risk in the 3.5% stated deficit. Importantly, the states face their own constraints and may well be ultimately allowed to breach the 3% deficit mark. Forced fiscal consolidation is not an option, whereas an expansion not supported by RBI via government bond absorption risks spiking sovereign yields and thereby working against the objective of financial conditions easing. To put the need in perspective the US economy that was still growing close to its long term trend growth rate pre-Coronavirus, has put together a fiscal package amounting to approximately 10% of its GDP. Not just this, the Federal Reserve is leveraging 10x capital injected by the US Treasury in various financing programs. This could ultimately mean a Fed lending program that matches or even exceeds the size of the government’s stimulus.
In contrast India has been growing substantially below its trend even before the virus. Thus it is almost a given that India will also have to ramp up its fiscal stimulus in the months to come. The important necessary condition for it do so is RBI effectively monetizing the incremental deficit. A fundamental flaw to be avoided is to not recognize the fiscal expansion embedded in expenditure expansion by assuming that the fiscal incentive now will quickly regenerate growth and hence tax revenues. Rather this has to be planned well and monetary policy has to support such expansion from the start in order to not let financial conditions tighten in response.
Investor Implications
Investors have understandably been very concerned with the very large market volatility in the past few weeks. It is here that speed of action from the central bank is also important alongside the size, since greater speed controls the unnecessary destruction of risk capital in the system. Nevertheless now that RBI’s hand is revealed, market volatility should substantially lessen allowing investors to focus on the medium term. From this perspective, quality bonds especially in the front end (up to 5 years) offer immense value. Spreads over repo are substantially higher than the average of the past few years even allowing for some correction today, and argue for immediate action from investors.
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