After weeks of intense market volatility, and with participants (including ourselves) bemoaning a premature tightening of financial conditions even as the growth outlook remains relatively dark, the RBI has unveiled a comprehensive response to the situation. Indeed, this addresses almost all issues that were challenging the bond markets. We summarize these measures below:
1. Forward guidance: The RBI notes in its press release that there are “indications that food and fuel prices are stabilising and cost push factors are moderating”. It also says that “the recent appreciation of the rupee is working towards containing imported inflationary pressures”. This latter point is important as the central bank seems to have gone somewhat light touch in absorbing incoming dollars lately, leading to an almost 2% appreciation in the rupee over the last fortnight. Basis the statement today it now appears that the RBI has selected this as the more effective tool to address aspects of the current inflationary episode, while ensuring that monetary policy tools continue working towards mitigating the growth risks. This has been further reiterated with the RBI committing to “ensuring comfortable liquidity and financing conditions in the economy”.
2. Additional Twist Operations: Apart from the 2 twist operations of INR 10,000 crores announced earlier and which are currently ongoing, the RBI has announced another 2 operations for INR 10,000 crores to be held in successive weeks. Furthermore, these are being backed by an open ended commitment for “further such operations as warranted by market conditions”.
3. Additional Term Repo: The RBI will conduct additional term repo operations for INR 1,00,000 crores at floating rate (prevailing repo rate) in the middle of September. While these are purportedly timed with advance taxes, this consideration may be of limited usage in a heavily surplus banking system liquidity environment. Rather, banks are being allowed to reduce cost of their earlier long term repos (taken at 5.15%) with the current rate (4%) through these operations as well. While this may not create incremental demand for assets (since assets would already have been purchased in the earlier operation), it nevertheless constitutes a significant additional spread earned by banks.
4. Held to Maturity (HTM) hike: This is arguably the most potent of the announcements made, and one that has been on the market’s wish-list for a very long time. Thus the RBI has allowed an additional 2.5% of deposits for banks as HTM for the second half of the current financial year (September – March). This allows an additional purchase capacity of approximately INR 3.6 lakh crores for banks without worrying about fluctuation risks over this period. Presumably bonds once bought under this facility will have HTM status for their lives, even as HTM for incremental purchases may be brought down again for the next financial year (RBI to review limit post 31st March).
Implications:
What is impressive here is the fullness of the response that the central bank has come up with. Thus from correcting the recent (unfortunate) muddling of the forward guidance post last policy minutes to addressing the demand-supply imbalance in the market, the RBI has re-established the confidence channel of the market. This will now restore normal functioning and allow the substantial borrowing requirement to start going through without undoing the transmission channel.
Having said that, it is also true that more than 50% of an INR 20 lakh crore plus (center and states combined) borrowing program is still ahead of us. To that extent one can argue that the announcements today were a “must have” if markets were to continue to behave in an orderly fashion. For that reason one shouldn’t expect a very large sustainable rally in bonds basis just the current set of triggers, although one should reasonably expect most of the recent aggressive sell-off to get unwound. However re-instatement of orderly functioning now allows participants to start deploying risk capital with more confidence to take advantage of what are quite attractive valuations given the underlying backdrop of an unprecedented growth drawdown and a collapse in credit growth.
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