The RBI announced a ‘twist’ operations by proposing to buy INR 10,000 crores worth of the 10 year bond and sell equivalent 2020 maturing bonds. This is for the first time that targeting term spreads has featured in RBI’s reaction function.
The Backdrop
1. There has been a more than 400 bps fall in India’s nominal GDP over a brief period of little over 1 year. Against this in terms of significant counter-cyclical responses, the government has done around 50 – 60 bps of a discretionary fiscal expansion. The MPC has cut repo rate by 135 bps . RBI has also proactively stepped up system liquidity to a comfortably large surplus. These have been complimented somewhat with a few macro-prudential measures. Given the quantum of the growth collapse, which is comparable now for India to the 2008-09 period, to say that this is adequate counter-cyclical response is stretching things a little, in our view. Thus the question really has been about where there is incremental space and what kind of policy is likely to best be effective.
2. Transmission is an issue that is well recognized. This in turn can be broken into high term spreads as well as credit spreads. The problem with respect to even the elevated sovereign yields has often been underappreciated.
Source: CEIC, IDFC MF Research
Term spreads (as measured by the difference between 10 year yield and that on 1 year treasury bill )are the highest since 2010. As the graph above shows, the widening is all the more remarkable now since it has been happening even as credit growth has collapsed and liquidity has been made abundant. The next graph below makes another stark point.
Source: CEIC, IDFC MF Research
Owing to rising term spreads, the fall in government bond yields hasn’t kept pace with falling nominal GDP growth rates. This has made the effective borrowing rate for even the sovereign very high, let alone the private corporate sector. Thus, just as commentators have observed that credit spreads need to be brought down for the riskier borrower, there clearly has been a need to bring down sovereign term spreads as well. While the effect to the overall system is decidedly lower than compressing the credit spread, it is still of relevance and can be executed with much less moral hazard.
3. The fiscal debate currently in India has often focused on the wrong problem, in our view. An expansion in government spending has helped compensate for a stagnation in the private sector over the past few years, in the backdrop of the twin (and now four) balance sheet issues.
Source: CEIC, IDFC MF Research
It is noteworthy that the current growth slowdown and collapse in deflator / core CPI is despite this higher government deficit. The problem then is not necessarily the absolute size of the deficit but rather its opacity and the simple fact that local savings can no longer match up with the level of borrowings. This phenomenon can only be corrected over a period of time. In the meanwhile, there is a role for both off-shore capital as well as for RBI to help alleviate the strain on domestic resources.
What The RBI Has Done
RBI has been proactive in ensuring surplus liquidity over the past few months, for the first time in a long time aligning all 3 pillars of easing of forward guidance, rates, and liquidity. However, liquidity hasn’t been getting converted into risk capital in a meaningful way for anything higher than the 1 year treasury bill. This has been evident in the widening of say even a 4 year government yield versus the 1 year treasury bill to around 125 bps. The so-called twist announced will supply more securities to the market in the tenor segment where liquidity was influencing buying interest (up to 1 year), and purchase segments where market liquidity wasn’t converting to risk capital. Absent outright OMO purchases (where RBI may be feeling constrained given the already excess liquidity; although one can argue it wouldn’t have mattered in practicality since this excess wasn’t inflationary by a long stretch), this is probably the best solution for compressing term spreads.
There may be some modest pressure on the 1 year rates, but it is unlikely to be material given that the hugely surplus system liquidity should keep interest alive in this segment even for ‘low involvement’ capital. RBI should largely restrict itself to selling only 2020 and at worst 2021 bonds. Higher maturities than that will probably defeat the purpose of the exercise.
Market Implications
From a market standpoint, what is noteworthy is that RBI is now explicitly targeting term spreads. Thus it is likely that there will be some persistency to these operations. RBI has enough front end assets in its balance sheet courtesy past OMO purchase operations. Given that long duration at the time of writing has barely unwound the post policy disappointment, and given that both in terms of steepness over 1 year bills as well as versus nominal growth rates valuations remain the most attractive in at least the last 9 years, we continue to prefer a long duration bias in our actively run dynamic bond and gilt funds. There is INR 1,35,000 crores of scheduled maturities of government bonds in January which should create some replacement demand. Investor interest (provident fund, insurance etc) is also likely to be reasonably strong in the final quarter of the fiscal year. These are shorter term factors that are also bond supportive.
The next big trigger will likely be the Union Budget. While the current operations of RBI may temporarily start reigning in term spreads, the government also needs to actively court foreign capital to part finance its deficit, at least in the near term. This can be rule based to avoid risk of excesses but must be done for now given the stark paucity of domestic savings.
Disclaimer:
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.
The Disclosures of opinions/in house views/strategy incorporated herein is provided solely to enhance the transparency about the investment strategy / theme of the Scheme and should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document has been prepared on the basis of information, which is already available in publicly accessible media or developed through analysis of IDFC Mutual Fund. The information/ views / opinions provided is for informative purpose only and may have ceased to be current by the time it may reach the recipient, which should be taken into account before interpreting this document. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision and the security may or may not continue to form part of the scheme’s portfolio in future. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. The decision of the Investment Manager may not always be profitable; as such decisions are based on the prevailing market conditions and the understanding of the Investment Manager. Actual market movements may vary from the anticipated trends. This information is subject to change without any prior notice. The Company reserves the right to make modifications and alterations to this statement as may be required from time to time. Neither IDFC Mutual Fund / IDFC AMC Trustee Co. Ltd./ IDFC Asset Management Co. Ltd nor IDFC, its Directors or representatives shall be liable for any damages whether direct or indirect, incidental, punitive special or consequential including lost revenue or lost profits that may arise from or in connection with the use of the information.