The Reserve Bank of India (RBI)'s latest policy actions are designed to improve the transmission of liquidity within the banking system. The central bank has taken multiple measures which, it hopes, will improve liquidity. For example, it is tightening the "liquidity adjustment corridor," by raising the reverse re-purchase rate, even as it lowers the re-purchase or repo rate.
The differential is now reduced to 0.5 per cent, from the previous one per cent. This means RBI will charge its member banks less for the cash it lends, and, at the same time, pay more if it borrows. This should make borrowing easier for commercial banks.
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RBI will also be more active in open market operations (OMOs). By increasing the scale of open market operations, it will put more liquidity into the system. It will purchase bonds and thereby infuse cash into the system whenever it thinks liquidity is tight. Alternatively, it will buy dollars and sell rupees for the same purpose of enhancing liquidity.
In general, more liquidity in the system means banks have less excuse for not transmitting rate cuts. RBI had cut the policy rate by a cumulative 125 basis points (bps) prior to the April 5 cut. Commercial banks had only cut their lending rates by 50-60 bps. The standard excuse for not passing on the full extent of policy rate cuts was tight liquidity.
Assuming RBI's liquidity measures work, that will no longer wash and banks will be forced to cut their rates. They will also have more money to lend out. The supply of more cash at lower interest rates should stimulate credit offtake and, thus, lead to more activity. Of course, this also implies banks will be less inclined to ensure strong due-diligence before sanctioning loans. This is a possible danger and quite significant, given huge existing Non-performing assets (NPAs).
The RBI policy statement also referred to action taken regarding forex swaps. It has to close out around $34 billion of swaps between September and December 2016. These date back to September 2013. The rupee was then under pressure, falling to historic lows of around 69 to a dollar.
RBI decided to build a war chest by instructing banks to offer FCNR deposits at attractive rates to Non-Resident Indians (NRIs). In turn, RBI did swaps with banks. It picked up $34 billion, offering discounted terms on the swaps to the banks.
A swap freezes the exchange rate. That is, the first leg of these swaps saw RBI giving banks rupees for dollars at a certain exchange rate. Closing out the transaction will involve the inverse swap, with RBI giving dollars and accepting rupees, at the same $ vs Rs rate. In addition, any agreed on interest rate or premium will be settled. RBI offered banks discounts to prevailing premiums on hedges in 2013. It will bear those costs as it closes out the swaps.
Assuming the dollar has strengthened from the averaged rates prevailing between September and December 2013, RBI may also bear exchange losses. However, that cost might not be too large, since the rupee was quite depressed in that period. At any rate, RBI has taken forward positions to cover those swaps.
We can make a few predictions on the basis of this policy statement. In general, a cycle where interest rates are slated to come down should be bullish. If you use the Consumer Price Index as a benchmark, real rates are still quite positive and there's lots of room to pare down.
Bank share prices had already discounted that cut to a large extent and so the initial impact was neutral and tending to negative, due to poor global sentiment. The effect of the additional liquidity measures were not, however, discounted. Those measures should have a positive impact on the bond market, pushing yields down. As and when banks do start cutting lending rates, there will be a positive impact on share prices as well. Similarly, there should be positive impact, as and when non-banking financial companies (NBFCs) start cutting rates.
There will probably be currency pressure on the rupee across September-December, however much the central bank tries to smooth the volatility out. The market will also expect another rate cut around that period if the monsoons have gone reasonably well. Investors will have to live with those expectations.
