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RBI reiterates its 'Long Pause' - Outside View by Arvind Chari
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RBI reiterates its 'Long Pause'
Apr 10, 2017

As was widely expected, the RBI held the Repo rate unchanged at 6.25% and also maintained its neutral monetary policy stance. The RBI though narrowed the interest rate corridor, with the Reverse Repo rate (the rate at which banks lend to RBI) now at 6.0% (from 5.75%) and the Marginal Standing Facility (MSF) now at 6.5% (from 6.75% earlier). The 25bps increase in the reverse repo rate is not to be seen as a rate hike, but as a calibrated move to ensure better liquidity and interest rate management.

The banking system is still flush with excess liquidity of more than INR 4 trillion (~USD 60 bln). This liquidity has resulted in overnight and short term rates trading below the Repo rate. For instance, the 91day treasury bill yield was trading at 5.75% as against the Repo rate of 6.25%. The Repo rate is the policy rate of the RBI. It is imperative for the conduct of monetary policy that the RBI maintain overnight and short term rates near or above the Repo rate. We were thus expecting RBI to take strong measures to suck out the excess liquidity and bring about sanity to short term interest rates.

The RBI has addressed it but chosen to do it in a non-disruptive manner. It is a smart move and likely to have its desired impact without too much market impact. Instead of hiking the Cash Reserve Ratio (CRR), they have chosen to raise the reverse repo rate and thus try and align the short term market interest rates. Along with this, they would also use longer tenor reverse repos, issue MSS (sterilization) bonds, Open Market Operations (sell government bonds) among others to manage liquidity at a level to maintain sanctity of the Repo rate. Short term rates (overnight and treasury bill rates) will move in the 6.0% - 6.25% band and move above the 6.25% mark as currency in circulation increases (people withdraw the re-monetized money from banks) and the liquidity surplus dwindles. We expect liquidity to get back to neutral from the current surplus in 2 more quarters.

Markets were not expecting any rate cuts in this policy review and hence the major focus was on the RBIs stance on liquidity management. But we found RBIs text on inflation outlook a wee bit hawkish and it thus has significant repercussions on the future rate trajectory.

The RBIs inflation projections for March 18 (4.8%) and of March 19 (4.6%) are higher than its desired 'medium term' target of 4.0%, which then suggests that if they intend to achieve the 4% CPI target in the near term, it would require a tighter monetary policy stance going ahead. Although, we expect the RBI to remain on hold for some time, if domestic food prices increase on weak monsoons and / or oil prices spike up, we would expect the RBI to hike the Repo rate to manage inflationary expectations.

"While inflation has ticked up in its latest reading, its path through 2017-18 appears uneven and challenged by upside risks and unfavourable base effects towards the second half of the year. Moreover, underlying inflation pressures persist, especially in prices of services. Input cost pressures are gradually bringing back pricing power to enterprises as demand conditions improve. The MPC remains committed to bringing headline inflation closer to 4.0 per cent on a durable basis and in a calibrated manner. Accordingly, inflation developments have to be closely and continuously monitored, with food price pressures kept in check so that inflation expectations can be re-anchored. At the same time, the output gap is gradually closing. Consequently, aggregate demand pressures could build up, with implications for the inflation trajectory. Against this backdrop, the MPC decided to keep the policy rate unchanged in this review while persevering with a neutral stance."

In the post policy conference call, the RBI did mention that the 4% inflation target needs to be achieved between 2017 and 2021, but the RBI seems intent on delivering it in a durable manner on a sustained basis and hence we expect no further rate cuts by the RBI. They would maintain a neutral stance with a long pause at 6.25% with a bias towards rate hikes on food/commodity price inflation.

Given that the INR has appreciated quite sharply in the last few weeks, the impact of global commodity prices will be softened and can be less of an issue. The real game now moves back to domestic factors. We would watch the food prices very closely in April and May. Vegetable prices tend to shoot up in summer and if they rise more than estimated, it would lead to a higher inflation trajectory. Following that would be outlook on monsoons. There is a lurking risk of El-Nino and lower than normal monsoons. Global food prices have been on the rise and it may be well be India's turn to follow the global trend if monsoons fail.

The most crucial development for the bond market is the evolving discussion on farm loan waivers. An agriculture economist had told us many years back, that given the farm economics in India, farmers cannot survive without farm loan waivers every 4-8 years. The UPA did an all India farm waiver in 2008, (a year before the 2009 election). The newly elected BJP government in Uttar Pradesh has passed a farm waiver amounting to USD 5.5 bln.

India is still a socialist country and no one can fight the logic of a farm loan waiver. Farmers are big vote base and it is an easy sell. If large corporate loans are being restructured, then why can poor farmers be given some relief. No wonder then, many other state governments are known to be evaluating waivers. Although, we commiserate on the plight of the poor farmers, but this has huge fiscal implications (both at the state and the Centre level). The bond market is clearly not pricing this risk.

Bond markets seemed more bothered with the hawkish inflation stance and as the RBI has indicated the use of Open market operations (OMOs) to manage liquidity. Given that the government borrowing for FY 18 would begin from this week, if the RBI also sells government bonds (OMO sales), it would result in excess supply and thus increase in bond yields. Bond yields rose 10 bps.

Bond yields can trend higher towards the 6.9% level, where like last time we should see value buying. Also, foreign investor interest seems extremely high and foreigners have now bought close to USD 5 bln since March. This may keep yields range bound in the near term.

But as we have been indicating since the start of the year, the best of the bond market gains are clearly behind us and investors should lower their return expectations from bonds and bond funds. We will closely watch global oil prices, the monsoon forecast and the evolving situation on the farm loan waivers across states. These remain the key risks to the bond market going forward.

Arvind Chari is Head Fixed Income & Alternatives at Quantum Advisors Pvt Ltd and advises two India dedicated off-shore India fixed income funds. Arvind was previously the fund manager for the Quantum Liquid Fund and the Quantum Equity Fund of Funds at Quantum Asset Management Company Pvt Ltd.

Disclaimer:

The views expressed in the Article are the personal views of the author, Arvind Chari and not views of Quantum Advisors Private Limited (QAS). QAS may or may not have the same view and does not endorse this view.

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