Central bank sets to cool bond yields affected by CPI and higher govt borrowings

The key takeaways from the October 2020 RBI Policy Statement are as follows:

  • MPC to continue accommodative monetary policy well into next financial year till there is a clear revival in the growth trajectory
  • An extended pause in rates based on an expectation of a moderation in inflation with easing of supply constraints in the next few months
  • Strong message that RBI will manage bond yields aggressively in the current year through larger OMOs which will also include SDLs
  • Steps such as extension of enhanced HTM limits to ensure strong liquidity in the financial markets and absorption of higher government borrowings
  • On tap TLTRO upto Rs 1 Lakh Cr for specific sectors along with regulatory tweaks such as lower risk weights on home loans with higher equity to push credit and rate transmission

The MPC reiterated its ‘whatever it takes’ stance to the market in the October 2020 MPC meeting as it assured continued accommodation till a clear growth revival is visible. RBI’s near term growth outlook was cautiously optimistic which forecast a contraction in real GDP by 9.5% while highlighting a few green shoots in the economic landscape. Touching upon the importance of shifting focus to revival from containment, the MPC clearly delineated its action plan with focus on growth revival instead of inflation targeting alone for an economy that is in contractionary mode.

While the MPC currently foresees the economy to contract by 9.5% in FY21, it is hopeful of a recovery towards Q3 and normalization by Q4 in line with the growth forecasts of Acuité Ratings. Based on high frequency data, it is noted that the rural economy has been fairly buoyant and has been driving the recovery in the consumption sentiment. Clearly, this is having a positive rub off effect on labor intensive segments such as tractors, consumer non-durables, vehicles, electricity and agro processing units. The strong support provided by the central Government by way of sponsored schemes such as MGNREGA has given a fillip to the rural sentiment in addition to the healthy monsoon and resultant bumper Kharif harvest expectations. With gradual unlocking of the economy, workers have started to move back to industrial centers as normalcy ensues in the urban areas. This will address the labour availability concerns as capacity utilization levels across the industrial sector are expected to normalize to pre Covid levels by Q4.

In our opinion, the current inflation trajectory with CPI print at 7.3% in Sept. 2020 may not permit any further rate cuts over the next few months. Further, the effectiveness of rate cuts has also been exhausted for now; we note that over the last 20 months, the MPC has cut interest rates by 250 bps in order to keep borrowing costs low and revive consumption and investment. However, one year MCLR has come down by just 114 bps between August 2019 and August 2020, despite significant liquidity accumulation by commercial banks and any further rate transmission particularly in the loan markets is not expected to be significant.

While the inflationary uncertainty may not permit any rate cuts over the next 3-4 months, RBI has clearly articulated that it will maintain an accommodative stance till the growth trajectory shapes up clearly. This is being ensured through rapid deployment of liquidity via the LAF window as well as Special Open Market Operations (OMOs). Additionally, special initiatives in the form of TLTROs and additional standing facilities have been made available to the banks for an extended period.

Assessment of the Financial System

The MPC took note of the stability provided by early monetary interventions in the form of Operation Twist (augmented yield management) by way of Special OMOs and TLTROs. RBI has announced that it will increase its OMOs to Rs. 20,000 Cr, which in our view may still be inadequate given the current scenario. It is also important to note that these auctions will include Special OMOs, which will be a form of Operation Twist in place of duration agnostic purchases.

Another important announcement comes in the form of ‘On Tap TLTRO’, augmenting the monetary operations that had been undertaken until September 30, 2020. Under the fresh TLTRO scheme, a window of Rs. 1 Lakh Cr will be available to the banks at a floating rate connected with Repo rate. Banks may avail the facility until March 2020 for a duration of up to 3 years and use the money to invest in bonds, NCDs and CPs or for deploying in loans and advances for specific sectors. Importantly, banks which have borrowed under the facility previously (TLTRO 1.0 and TLTRO 2.0) may reverse the transactions before maturity; this in our opinion will offer additional flexibility to financial institutions.

Importantly, the RBI has also extended the duration for banks to hold excess SLR securities under the Held to Maturity (HTM) category up to March 2022. This is applicable to only those securities that will be acquired between Sept. 2020 and March 2021. Earlier, commercial banks had been allowed to keep SLR securities under the HTM category to the tune of 22% compared to 19.5% kept historically March 2021. We believe this will not only allow banks to save their treasury holdings from mark to market risk but also insulate the gsec yields from market related pressures.

To address the borrowing challenges of the states, RBI has allowed OMOs pertaining to SDLs. This is under special circumstances and is likely to remain in place as long as it is necessary. Taken together, these measures are expected to provide durable liquidity in the system and hopefully, will allow percolation of accommodation to the borrowers.

Assessment of Inflation

MPC’s deliberations on interest rates have turned increasingly complex, given the mixed signals emanating from macro variables, especially the inflation print(CPI). It is observed that despite poor consumer demand, Sept. CPI printed 7.3% on the back of August CPI at 6.9%, 330 bps higher than the upper bound of the RBI’s inflation targeting corridor. It is known that the food basket has continued to experience upward pressures throughout the pandemic period due to supply shocks pertaining to vegetables and protein based items such as poultry. Despite the expectation that these pressures will taper September onwards (when the unfavorable base effect will reverse), there seems to be a concern on the impact of other supplementary factors.

Considering the non-food basket of the CPI, we believe that the committee is particularly concerned about the fast changing dynamics in the commodities and industrial activity. While it is noted that that industrial activities are in a contractionary mode in the second quarter as well, there are signs of improvements none the less. Purchasing Manager’s Index (PMI) Manufacturing, a variable that precedes the IIP has already breached the 56 level in September and is thus officially in the expansion phase.

Rural revival on the back of healthy monsoon and consequent growth in kharif sowing is another concern as far as the inflation print is concerned. Based on previous observations, we note that rural inflation generally outperforms its urban counterpart because of weaker supply chains and a much smaller base. It has also been empirically seen that when there are higher chances of a good agricultural production, rural sector tends to exhibit strong consumption patterns, which are also partly financed via credit. Given the current situation, it is prudent to consider the all-important rural factor while assessing the future inflationary outlook.

Overall, the MPC, as an RBI functionary of monetary policy – has holistically assessed the macro economic situation to reach a consensus on rates and devise necessary liquidity support for the system. The MPC has affirmatively maintained its accommodative stance and is expected to do so as long as it is necessary. Going forward, RBI will continue to take initiatives pertaining to digitization which will strengthen the monetary institutional framework further leading to a more effective response to a rapidly evolving situation.