The RBI Governor announced a new set of measures in response to the current growth and financial market stress. These measures are mostly aimed at easing some pressures on the lower rated / smaller participants of the financial markets. For the general bond and money markets, the major announcement pertains to a further widening of the liquidity adjustment facility corridor with the reverse repo rate being cut by a further 25 bps to 3.75%. Repo rate (the mandate of the Monetary Policy Committee) and the marginal standing facility rate are kept constant. Ways and means advance (WMA) facility for states has been enhanced by 60% (instead of the 30%) announced earlier, available till 30th September. Also, the liquidity coverage ratio (LCR) has been temporarily reduced to 80%. Other measures are as follows:
1. A new targeted long term repo (TLTRO) for INR 50,000 crores has been announced directed at NBFCs. This has to be in investment grade instruments and 50% has to be allocated to small and midsize NBFCs and MFIs. Deployment has to be within 1 month and the investment can be under additional held to maturity (HTM), as before. Also exposure will not count under the large exposure framework.
2. All India financial institutions (FIs) NABARD, SIDBI, and NHB will get a cumulative special refinance facility for INR 50,000 crores at the RBI’s repo rate.
3. Various asset classification relaxations have been provided, including standstill on classification of accounts undergoing moratorium, between 1st March and 31st May. However, banks will have to provide additional capital on the standstill accounts. Also importantly banks have been disallowed from making any dividend payments from profits pertaining to the financial year ended 31st March 2020 until further instructions.
Importantly, the Governor has clearly indicated that all facilities are largely open ended and can be enhanced as needed. He also provided the same assurance on overall RBI steps. Finally, he presented a benign analysis of Consumer Price Index (CPI) noting that it will likely settle below the target of 4% by second half. This will provide more space for monetary policy.
Assessment
The new set of measures are welcome, and will serve to ease financial conditions on the margin. However, it is possible that the RBI is still somewhat underestimating the fact that the real problem (in our view) is that of inadequate availability of risk capital in the system. Thus, some of the “push” measures may likely have limited impact. As an example, banks’ may still hesitate to lend to weaker credits under the new TLTRO since the dispensation is on market risk and not credit risk. As another, while the lower reverse repo is a good push incentive, a more powerful one could have been general timebound HTM relaxations for banks investment in government bonds.
Apart from the selective measures towards easing liquidity flow to various aspect of the economy (which anyway will also be a function of the risk perception of lenders), there’s a general pressure even in the quality part of the bond market. Thus sovereign yields have been inching up for mid to long end bonds because, amidst general inadequate availability of risk capital, the deficit financing plan ahead is quite murky. Thus while it is somewhat reasonable to expect at least a 400 bps combined expansion in central plus state deficit, the absorption plan for this supply is as yet unannounced. To be fair to the RBI, it may be awaiting the actual announcement of borrowing to unveil the absorption plan. However, in another way, it seems to have largely abandoned its focus on the market channel of transmission for now. It may be recalled that the so-called Operation Twist had been devised to incentivize the market transmission channel (influence corporate bond yields via influencing government bond yields). The seeming apathy when this channel now lies broken at a time when the country’s nominal GDP growth rate is collapsing further, is somewhat surprising. Thus, the general narrative has been that the quality borrowers have been cornering RBI’s liquidity. Sufficient attention isn’t being paid to where the cost of money is for the quality borrowers themselves (including the government of India) in relation to the forecasted nominal growth rate of the country.
Takeaways
The measures today are relatively small in terms of their impact on the quality part of the bond market. Their effect on lower rated borrowers will depend upon risk appetite of lenders as mentioned above. From an absolute risk versus reward perspective, front end (up to 5 year) quality bonds provide the best value. Long duration is quite attractive as well, both on term spreads as well as on gap from expected nominal GDP. However, its sustained performance will importantly depend upon the RBI unveiling a credible plan for financing the substantially expanded fiscal deficit in the year ahead.
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