Upping its recent proactive stance on liquidity, the RBI announced an even higher pace for Open Market Operation (OMO) for the rest of the financial year. Thus it increased the quantum for December by INR 10,000 crores to INR 50,000 crores. It also announced INR 50,000 crores for January and guided that it will ‘consider similar quantum of OMO purchases until end of March 2019’. Of course, relevant usual caveats around currency in circulation (CIC), forex operations etc. have been given. It may be remembered that one of the key highlights of the December policy was Dr. Acharya saying that the increased frequency of OMOs may be required till March. At the time the market had assumed this to mean the INR 40,000 crores announced OMOs for December would get replicated over January to March. The current announcement ups this by another INR 10,000 crores per month for this period. If this revised pace indeed gets delivered, the RBI would have bought a staggering INR 3,36,000 crores in the current financial year. This will total to more than 80% of the net borrowing program of the central government for the current financial year.
There are a few important takeaways from the new OMO announcement:
1. This displays full continuity in RBI policy with respect to monetary policy measures. Thus it may be recalled that Dr. Patel and Acharya had continued recent history when choosing OMOs over CRR as the preferred tool for liquidity infusion. In fact, the question of CRR usage had been summarily dismissed in the post policy conference calls in December. With a change in Governor, there was an expectation in some quarters (and fear in bond market) that the tool may get discussed again. However, this stepped up pace of OMOs puts back to rest this speculation.
2. This re-emphasizes the commitment of RBI to achieve neutral core liquidity at the very least. Also, and somewhat unlike previously, now this is being done very proactively basis forward liquidity calculations. Dr. Acharya had laid out the liquidity objective in some detail in the December policy. Thus he had explained that RBI was guided by principle of managing system-wide liquidity. It is also the lender of last resort wherever needed, but he didn’t think that was required currently. This principle also seems to be getting preserved after the change in Governor, with possible sector level liquidity shortages potentially driving RBI to be even more proactive on system-wide liquidity.
3. With this quantum of OMOs, the impact of minor supply deviation on government bonds owing to small potential fiscal slippages may well get masked. To be clear and as noted before, although we think the actual run rate so far is tracking a slippage, it may still happen that no slippage is actually shown by deferring some spending items. Also, a small slippage may not necessarily translate into additional borrowing through dated securities. One can always levy a charge that the RBI is incentivizing slippages in some sense by taking out such large amounts of government bonds from the market. However, this has to be looked at as an unintended cost of policy. There is little other option, given the ask on liquidity creation and given that RBI wants to retain the current CRR levels. We aren’t too sympathetic to the idea of longer term repos. For one, CIC is an annual phenomenon and will be a drag on core liquidity next year as well. Assuming the same RBI dividend to the government, the only other offset will be if balance of payment (BoP) turns substantially positive and RBI buys those dollars and creates rupee liquidity. However, it will not be prudent to take a view on this. Also, banks may be reluctant to lend forward temporary liquidity provided to them, even if the liquidity provided is of a somewhat longer term.
Investor Implications
The current rally seems to be getting treated with suspicion by most investors. The context is understandable, since the past year has seen a rapid rise in yields and mark-to-market losses. Also, just a few months back the general wisdom of the market was to expect successive further rate hikes. Also potentially adding to suspicion is the fact that this staggering quantum of OMOs may be artificially holding down government bond yields. So this begs the question, what happens when those OMOs cease; possible at beginning of next financial year? Against these concerns, however, one should keep the following points in mind; in our view:
1. The 175 bps odd rise in yields between mid of 2017 to September 2018 (taking 10-year government bond as benchmark) has been matched or surpassed only twice before in the last 10 years. Both those times were exceptional. The first was 2009, when the government responded to the global financial crisis with a huge deficit expansion and consequent large scale excess borrowing. The second was 2013’s taper tantrum when India was running double digit CPI and almost 5% current account deficit. It is especially noteworthy that the current episode happened without any large macro imbalance in our system. The point is that this magnitude of volatility is a rare phenomenon and shouldn’t colour asset allocation decisions of investors.
2. There is a global context also to the current bond rally. As we have elaborated elsewhere, there is a case that the unsynchronized recovery theme underway for most of 2018 may be giving way to a period of synchronized slowdown. The action from commodities and yields curves, as well as variety of economic data, certainly seems to be suggesting as much. If indeed this is the case, then there is a case for fundamental shifts in asset allocation tables in favour of quality fixed income; rather than just looking at the current phase tactically. Thus the rate cycle has peaked and the RBI is already more sensitive than any time in recent history towards provisioning of adequate liquidity. If the global context remains as it lately is, then from here to explicit easing is just one step ahead.
3. The ‘OMO effect’ is most certainly impacting government bond yields. This is getting clearly evidenced in a large widening of AAA and SDL spread over government bonds. Thus as an example, AAA spread over corresponding government bond is around 100 bps at the 5-year point. To take another valuation metric, 5-year AAA to repo rate spread at between 175 – 200 bps is still attractively placed when compared with its 5-year history. Thus to us the choice is more of which risk – reward point to participate in rather than ignoring altogether what may just be a sustainable turn in the environment for high quality fixed income allocations.
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