Three Wrongs That The ‘No Rate Cut’ Decision Helped Fix

The monetary policy committee’s decision to keep rates unchanged this week came as a surprise to the market. In hindsight, though, it appears to have been the right thing to do for both tangible and intangible reasons.

With the quick-reaction commentaries out of the way, many are now accepting that RBI governor Urjit Patel has managed to fix some market anomalies through the decision while also correcting some misconceptions about his own leanings.

Normalizing Bond Yields

The benchmark 10-year bond yield saw its biggest one day jump in almost three years on Wednesday from below 6.20 percent to 6.40 percent. Those levels held on Thursday. A number of bond market participants had gone into the policy expecting a 50 basis point cut as was reflected in the fact that the 10-year yield had continued to trade below the repo rate. In simple terms, a 10-year yield below the overnight repo rate suggests that it costs less to borrow for the long term than the short term.

The anomaly had been created by the surplus liquidity conditions in the banking sector due to the withdrawal of Rs 500 and Rs 1,000 currency notes. But it had continued even after the RBI sucked out surplus liquidity through a cash reserve ratio hike and through the issue of market stabilization scheme bonds.

Allowing this to continue could have led to mispricing of risk, said a bond market trader. A mispricing of risk happens when lower quality credit can borrow at rates that don’t accurately reflect the investment risk. A surplus liquidity situation can easily lead such exuberant lending.

By keeping rates steady and by clearly telling the market that the current surplus liquidity conditions are transitory, the RBI has managed to normalize the bond markets to some extent with the 10-year yield trading above the repo rate now, although the gap between the repo rate and the 10-year yield remains thinner than normal.

Soumyajit Niyogi, associate director - credit and market research at India Ratings & Research, a credit rating agency and one of the few that had accurately forecast that the RBI would keep rates on hold, says that Wednesday’s policy has helped clarify a lot of confusion in the market.

Stabilizing The Rupee

The currency experienced collateral benefit of the ‘no rate cut’ call. The rupee rebounded after the policy announcement on Wednesday on hope that outflows from the debt market will slow as domestic yields move up. On Thursday, the rupee closed at 67.35 against the U.S. dollar compared to 67.90 on Tuesday before the policy.

The narrowing yield differential had put India on the backfoot. According to a December 8 research report by global financial house Nomura, Indonesia and India saw the steepest debt market outflows in November.

Outflows in November of Rs 17,270 crore were the largest since the taper tantrum in 2013 when foreign investors sold Rs 29,300 crore. Foreign investors (excluding long-term investors such as sovereign wealth funds) reduced their holdings of Indian government bonds by Rs 14,660 crore in November, while long-term investors reduced holdings by Rs 1510 crore, Nomura highlighted in its report.

To be sure, outflows from emerging market debt could continue as we head into a likely interest rate hike from the U.S. Federal Reserve and as the market tries to assess U.S. President-elect Donald Trump’s economic policies.

However, by normalizing yields, the RBI will prevent any extra-ordinary pressure on the Indian currency.

Addressing Perception Issues

Apart from those two tangibles, the decision and the communication that followed also managed to correct some misconceptions that have crept in.

The first monetary policy review led by Patel in October had left many analysts thinking that Patel was a ‘dove’ and would be softer on inflation than predecessor Raghuram Rajan. This was contrary to what the market thought of Patel before he took over. At the time, the view was that Patel, the architect of India’s inflation targeting framework, would prioritize inflation control over growth.

Following Wednesday’s policy decision, analysts are shedding the perception that Patel will go soft on inflation. The decision to keep rates steady, despite a cut in growth estimates, was endorsed by all six monetary policy committee members including Patel. While many economists still see scope for rate cuts down the line, they acknowledge the prudence of waiting for incoming data on the impact of demonetisation before taking a call.

On demonetisation, Patel finally did take questions on the decision to withdraw Rs 500 and Rs 1,000 currency notes. The decision was not taken in “haste” and the central bank and the government had accounted for the near-term disruption that the withdrawal of notes will cause, said Patel.

That may not come anywhere close to being a satisfactory response to all the questions raised about the thought, the process and the planning that did or did not go into demonetisation, but it does break the silence that Patel has been chastised for.