The RBI has resorted to many short term measures to stem the panic caused by the INR fall to record lows of Rs 68.80 against the USD in August 2013. Unfortunately the shot term measures have wider implications for the longer term and the central bank faces a tricky situation when it goes into the 29th October 2013 policy review.
The bond market is going into 29th October 2013 policy with both certainty and uncertainty. The market is certain of a 25bps repo rate hike from 7.5% levels to 7.75% levels. The market is however uncertain of RBI ‘s actions on liquidity. Will the central bank lower MSF (Marginal Standing Facility) rate by 25bps from 9% to 8.75% to take the Repo – MSF spread to its normal 100bps? Will RBI remove restrictions on banks access to LAF (Liquidity Adjustment Facility) by taking off the limit of 0.5% of NDTL (Net Demand and Time Liabilities) that was imposed in July 2013? Will RBI wait for all the USD/INR swap windows that are open as of present (oil companies as well as for FCNR B deposits) to close before removing liquidity restrictions? What is the intention of term repo auctions?
Markets have a lot of questions on the liquidity front. Expectations are that MSF rate will be brought down by 25bps if repo rate is hiked. Opinion is divided on removing restrictions on LAF borrowings of banks. Markets believe that RBI wants to develop a money market yield curve through the term repo auctions. The question is what will the RBI achieve by keeping overnight rates at 8.75% levels (assuming that MSF rate is lowered by 25bps and banks restrictions on LAF stays)?
RBI by maintaining the MSF rate as the operational rate will essentially be signaling that all is not over for the INR. The INR has come off by 10% against the USD from lows seen in August largely on the back of the Fed postponing it’s tapering. The Fed is expected to maintain bond purchases until early 2014 given the debt ceiling issues the US is facing. The INR is a beneficiary of the Fed maintaining its asset purchase program size but RBI will have to be prepared for a situation when the Fed tapers off at a time when the country is going into general elections.
RBI will also have to worry about the CAD (Current Account Deficit). Lower CAD on the back of restrictions on gold imports is not sustainable. Import restrictions have to be removed as it artificially keeps down trade deficit. Trade deficit for the April-September 2013 quarter is down 40% from the previous quarter on the back of a 76% drop in gold and silver imports. The question is what will happen to the INR once import restrictions are removed?
The questions of growth and inflation will also have to be addressed by the central bank. Inflation as measured by the WPI (Wholesale Price Index) is trending at seven month highs on the back of food inflation that is at a whopping 18% levels. CPI (Consumer Price Index) is trending at 9.84% levels and has been trending at over 9% for the last many months. Economic growth however is faltering with GDP growth estimates for fiscal 2013-14, dropping sharply to decade low levels of 5% and below. Raising repo rates and keeping liquidity tight in the system will pull down growth but will not bring down inflation that is driven by food prices.
Bond markets are going with yield curve steepening expectations into the policy. Benchmark ten year government bond yields rose 3bps week on week to close at 8.58% levels while the yield on the benchmark six year bond fell by 1bps. Five and ten year benchmark AAA corporate bond yields fell 13bps and 3bps respectively week on week as markets bought into higher levels of yields on expectations of lower overnight rates. The OIS (Overnight Index Swap) market saw one year OIS yields fall by 13bps while five year OIS yields stayed flat week on week.
RBI lowering MSF rate and removing restrictions on banks access to the LAF window will help steepen the yield curve. However if RBI does not ease overnight money market rates, yield curves will see steep inversion as markets factor in further trouble for the economy.
Banks are borrowing around Rs 86,000 crores from the RBI. Banks borrowing in the LAF and MSF window was Rs 40,800 crores and Rs 25,400 crores while borrowing from 14 day term repo auction was Rs 19,500 crores. RBI would look to ease banks liquidity requirements through more term repo auctions as it provides stable funds at market bid rates.