The monetary policy review was almost entirely along expected lines from a bond market standpoint. It nevertheless served the important function of reaffirming RBI’s framework for responding to these highly unusual and distressing times. All rates were kept unchanged and the accommodative stance was continued. Growth forecast was brought down by 100 bps (real GDP now projected at 9.5% for FY22) while inflation forecast was bumped up by 10 bps (CPI now at 5.1% for FY22). Risks to inflation are two sided with rising global commodity prices and worsening logistic costs to some extent balanced with local factors like good monsoon expectations and possibility of weaker price pass throughs owing to relatively more muted demand conditions. The policy has persisted with a state based guidance recognizing the increasing difficulties in reinstating any sort of a time based approach. However, there seems to be sufficient patience embedded in the guidance for the market not to worry about any imminent shifts in stance. Moreover, the bond market got the much anticipated announcement for GSAP 2.0. This will be conducted over Q2 FY22 for an amount of INR 1.2 lakh crores (within range of market expectations) even as a balance of INR 40,000 crores is left from GSAP 1.0 to be conducted on June 17th.
Main additional measures
- On-tap liquidity window for contact-intensive sectors – Separate liquidity window of Rs. 15,000 crs is being opened till 31 March 2022, with tenors of up to 3 years at the repo rate, under which banks can provide fresh lending support to hotels and restaurants, tourism, etc. Banks can park their surplus liquidity up to the size of the loan book created under this scheme with the RBI at 40 bps above the reverse repo rate.
- Special liquidity facility to SIDBI – Special liquidity facility of Rs. 16,000 crs to SIDBI for on-lending/refinancing through novel models, to further support funding requirements of smaller MSMEs, etc. This facility will be available at the prevailing repo rate for a period of up to 1 year, which may be extended depending on usage.
- Enhancement of exposure thresholds under Resolution Framework 2.0 – Expanded coverage of borrowers, for the scheme announced on 05 May 2021, by enhancing maximum aggregate exposure threshold from Rs. 25 crs to Rs. 50 crs for MSMEs, non-MSME small businesses and loans to individuals for business purposes.
- Placement of margins for G-Sec transactions on behalf of FPIs – Decided to permit authorized dealer banks to place margins on behalf of their FPI clients for their transactions in G-Secs (including
- SDLs and t-bills), within the credit risk management, to ease operational constraints faced by FPIs
- Facilitating flexibility in liquidity management by issuers of Certificates of Deposits (CDs) – In Dec 20, RRBs were permitted to access liquidity window of RBI and call/notice money market. They are now permitted to issue CDs to provide greater flexibility in raising short term funds and liquidity management. Also CD issuers will be permitted to buy back their CDs before maturity, subject to certain conditions.
RBI’s Implied Framework
There are certain implied aspects of the RBI’s framework with respect to managing local financial conditions that have been fleshed out over a period of time both in the Governor’s speeches as well as with follow through actions from the central bank. We have been highlighting these over a period of time and take this opportunity to do so again today:
1. RBI now links bond yields and corporate bond spreads much more closely to its assessment of general state of financial conditions. In some sense the evolution here is to move from just a theoretical assessment to a more practical markets-driven approach. What it means for the bond market is that the central bank is regularly present, almost concurrently responding to modulate and signal as required. This is evidenced in its weekly interventions in bond auctions to cancel or devolve as it deems appropriate in order to signal to the market. It then supplements such intervention with other tools like sporadic open market operations (OMOs) and operation twists (OTs) which are over and above the pre-announced GSAP program. In our sense, it was dialing down on the intensity of these combined operations post the first wave. This is because it was transiting from an emergency mode to a still dovish but more business as usual mode. The second wave seems to have now transitioned the central bank (at least for the time being) to some notches higher from business as usual dovishness even as it may not be back to the full emergency mode of last year. Thus the strength of its operations in the market has also correspondingly picked up for now. Looked at in this way, the bond market equivalence of business as usual dovishness was the Governor’s emphasis on ‘an orderly evolution of the yield curve’ which seems altered for now to expressing a firmer view of where yields should be (even though he maintained the orderly evolution stance in the post policy press conference) in light of the stepped up dovishness of the central bank. This is getting evidenced as a more hands-on approach to the bond market as mentioned above.
2. The central bank very clearly perceives our very significant forex reserves as the first and primary line of defense against global spill over risks. While this may always be true in an emerging market context, there are nevertheless nuances associated with the current policy regime that are distinct. In our view, the RBI now assigns a higher weight to reserve accretion as a standalone objective versus earlier when forex reserve movements may have been considered more a byproduct of the currency volatility management strategy (even though the Governor’s press conference statement stuck to the historic line of volatility management, he did touch upon the need for emerging markets to build buffers). With this war-chest in place, it finds more room for itself to pursue looser financial conditions locally as it deems currently appropriate to the local context, without worrying as much about external dependencies. Of course, this can only be done within reason and doesn’t mean that RBI can insulate the local market from offshore led tightening in financial conditions if it were to come about. However, it does mean that it is muting the effect for now and we may not necessarily have to respond to every change in US bond yield, as an example.
Takeaways
Monetary policy seems very focused on being predictable for now, recognizing fully that there may be a considerable impact of the second wave on incomes and hence demand. Thus even as the recent evolution of global commodity prices and their local spillovers pose interpretational challenges for inflation, the guidance is unaltered and RBI’s enhanced level of commitment to maintain easy financial conditions stands reaffirmed. Even though this means an enhanced level of intervention in the bond market as well (as discussed above), our base case would remain that eventually RBI’s intensity of intervention will need to get dialed back and hence we would continue to budget for an orderly rise in yields over time. However, this by itself provides for reasonable opportunities given the current steepness of the curve even at intermediate duration points (3 – 6 years). Put another way so long as the RBI is broadly committed to containing volatility and muting the impact of excess bond supply, the steepness of the curve provides for enough cushion even if one has to give some of this away as mark-to-market losses. However, one has to be careful not to extend duration so much that potential mark-to-market losses start overwhelming the excess carry made.
Thus local factors are unlikely to pose a significant challenge to a somewhat constructive view on intermediate duration at least for the foreseeable future. The risk is rather from the prospects of ‘imported tightening’ (developed market bond yields go up and that rubs off on us). One has to take this aspect as it comes and we can only note the following mitigating factors for now: 1> The US Fed is much more patient in this cycle given its revised reaction function (average inflation targeting, responding to realized rather than anticipated outcomes, and higher implicit relative importance to an equitable recovery of the labor market) 2> A rather sharp round of a reflation trade seems to already have been played as both US bond yields as well as rate hike expectations have stopped climbing since early April (although this can very easily change with incoming data) 3> The RBI’s own preference for first using the forex reserve defense while persisting with pursuing easier local financial conditions to the extent required by local growth versus inflation trade-offs.
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