The Reserve Bank of India (RBI)'s decision to raise the repo rate by 25 basis points to 7.5 per cent surprised the market but it is clearly an attempt to move ahead of the curve. According to the RBI policy statement, "WPI (Wholesale Price Index) inflation will be higher than initially projected over the rest of the year, whereas inflation at the retail level measured entrenches inflation expectations at elevated levels". Clearly, the central bank is wary of an uptick in inflation at this point. Additionally, the repo rate is not the operational rate as of now and this has been clearly indicated in the RBI statement.
The decision to reduce the Marginal Standing Facility (MSF) rate by 75 basis points will reduce the effective cost of borrowing for banks. In our view, the negative carry (weighted average cost of borrowing being higher than 10-year yields) might also be rectified with the reduction in MSF rates.
Interestingly, there is a downside to which RBI could have reduced this MSF rate, as a significant cut might have negated the attractiveness of the Foreign Currency Non-Resident (Bank) [FCNR (B)] window fund mobilisation. It is to be noted a cumulative $1.4 billion of funds have already come in (ECB & FCNR (B) route), since it has been opened. This will be positive news for the rupee, as it will directly bolster foreign exchange reserves, which haddeclined by close to $17 billion in the current financial year (till September 6).
The move by RBI to tweak the repo and MSF rates will correct the yield curve inversion, by pushing down the short-term. But pushing up the long-term rates at the same time. In our view, short-term rates will now get aligned with the MSF rates (three-month CP and CD rates have already corrected by 10 basis points after the policy announcement). There will be now an increase in long-term rates, though the upside will crucially depend on how far we are able to offset the tighter liquidity conditions by concomitant open market operations (ideally, the upside to the representative long-term rate might be capped at 8.5 per cent, the average of repo and MSF, instead of the 8.75 per cent average earlier). Interestingly, there might be also a counterbalancing factor here, with the liquidity injection in lieu of FCNR (B) and ECB fund flow swaps. A third factor, that might be liquidity-negative, is the swap deal with oil marketing companies currently in place. The good thing is that RBI believes such swap deals will be done away with over a point of time, as the currency stabilises. There are also other factors being liquidity-negative, like no redemption of government securities scheduled before February and the daily Cash Reserve Ratio (CRR) requirement being frozen at 95 per cent, implying CRR is effectively at 4.1 per cent. Overall, we believe the direction of interest rate movements will be also influenced by the announcement of the second-half government borrowing programme next week. Thus, an upside to 10-year yield movements could not be entirely ruled out and we believe it may move in the range of 8.25-8.75 per cent. On the downside, 10-year yields are not likely to rebound below eight per cent in the current financial year. In terms of fixed income specifics, with the possibility of the yield curve correcting, it may be worthwhile to stay invested in the five to six-year bucket.
RBI has clearly said it has started the process of cautious unwinding of the exceptional measures. The extent will also depend on the direction of the US Federal Reserve tapering, that the central bank believes might have been just postponed. Here, we have an interesting anecdote. According to our prognosis, neither the unemployment levels nor the inflation rate in the US is showing any tangible movements that may trigger quantitative easing reversal immediately. The US labour markets have created involuntary part-time jobs suggesting employers do not want to hire full-time workers. If this is the case, we may have got a window from the Fed to our advantage! Let us use this interregnum to address domestic structural bottlenecks.
The author is chief economic advisor, State Bank of India. Views are personal
The decision to reduce the Marginal Standing Facility (MSF) rate by 75 basis points will reduce the effective cost of borrowing for banks. In our view, the negative carry (weighted average cost of borrowing being higher than 10-year yields) might also be rectified with the reduction in MSF rates.
Interestingly, there is a downside to which RBI could have reduced this MSF rate, as a significant cut might have negated the attractiveness of the Foreign Currency Non-Resident (Bank) [FCNR (B)] window fund mobilisation. It is to be noted a cumulative $1.4 billion of funds have already come in (ECB & FCNR (B) route), since it has been opened. This will be positive news for the rupee, as it will directly bolster foreign exchange reserves, which haddeclined by close to $17 billion in the current financial year (till September 6).
The move by RBI to tweak the repo and MSF rates will correct the yield curve inversion, by pushing down the short-term. But pushing up the long-term rates at the same time. In our view, short-term rates will now get aligned with the MSF rates (three-month CP and CD rates have already corrected by 10 basis points after the policy announcement). There will be now an increase in long-term rates, though the upside will crucially depend on how far we are able to offset the tighter liquidity conditions by concomitant open market operations (ideally, the upside to the representative long-term rate might be capped at 8.5 per cent, the average of repo and MSF, instead of the 8.75 per cent average earlier). Interestingly, there might be also a counterbalancing factor here, with the liquidity injection in lieu of FCNR (B) and ECB fund flow swaps. A third factor, that might be liquidity-negative, is the swap deal with oil marketing companies currently in place. The good thing is that RBI believes such swap deals will be done away with over a point of time, as the currency stabilises. There are also other factors being liquidity-negative, like no redemption of government securities scheduled before February and the daily Cash Reserve Ratio (CRR) requirement being frozen at 95 per cent, implying CRR is effectively at 4.1 per cent. Overall, we believe the direction of interest rate movements will be also influenced by the announcement of the second-half government borrowing programme next week. Thus, an upside to 10-year yield movements could not be entirely ruled out and we believe it may move in the range of 8.25-8.75 per cent. On the downside, 10-year yields are not likely to rebound below eight per cent in the current financial year. In terms of fixed income specifics, with the possibility of the yield curve correcting, it may be worthwhile to stay invested in the five to six-year bucket.
RBI has clearly said it has started the process of cautious unwinding of the exceptional measures. The extent will also depend on the direction of the US Federal Reserve tapering, that the central bank believes might have been just postponed. Here, we have an interesting anecdote. According to our prognosis, neither the unemployment levels nor the inflation rate in the US is showing any tangible movements that may trigger quantitative easing reversal immediately. The US labour markets have created involuntary part-time jobs suggesting employers do not want to hire full-time workers. If this is the case, we may have got a window from the Fed to our advantage! Let us use this interregnum to address domestic structural bottlenecks.
The author is chief economic advisor, State Bank of India. Views are personal