Message From Money Markets To The RBI: It’s (Still) All About The Liquidity
India’s monetary policy committee is widely expected to pare its benchmark repo rate by another 25 basis point this week, which would make this the third rate cut in 2019.
The first two rate cuts, however, have been only partially transmitted to the broader economy. Bond yield remained stubbornly high through most of the year, although they have now eased due to a confluence of global and local factors. Bank lending rates, too, haven't fallen much as lenders have been reluctant to cut deposit rates amid tight liquidity conditions.
It’s against this backdrop that money market veterans are calling for a review of the RBI’s liquidity policy, along with any further interest rate cuts.
“Of course we need lower rates. But what we need to see first is the market rates come down. We need to see bank deposit rates, lending rates and bond yields drop,” said R Sivakumar, head of fixed income at Axis Mutual Fund, in a conversation with BloombergQuint. “Without that, the RBI can keep cutting the overnight rate and there will no effect on the real economy.”
Real interest rates, as measured by bank fixed deposit rates or lending rates minus inflation, continue to remain very high. At the end of the day, that’s what matters when it comes to the real economy and not what the inter-bank lending rate is.R Sivakumar, Head (Fixed Income), Axis Mutual Fund
The RBI currently follows a liquidity framework where it tracks the inter-bank call money market to judge liquidity conditions. So long as the overnight rates in that market remain close to the benchmark repo rate, the central bank believes that large scale liquidity intervention may not be needed.
Market participants, however, argue that the RBI needs to look at other indicators such as spreads charges for various categories of bonds over government bond yields to judge the actual liquidity conditions.
“If you have a sustained liquidity surplus, it does help transmit lower rates much quicker into the ecosystem,” said Ananth Narayan, associate professor of finance at the SP Jain Institute of Management and Research.
The liquidity framework has to be an adjunct to the monetary policy framework. If you want easier monetary policy transmitted, having surplus banking liquidity makes an enormous difference. In fact, Dr Raghuram Rajan did acknowledge this in April 2016, when he finally overturned a five-year-old RBI policy to move banking liquidity to neutral.Ananth Narayan, Associate Professor of Finance, S.P. Jain Institute Of Management And Research
What Liquidity Tool To Use?
In FY19, the RBI bought nearly Rs 3 lakh crore in government bonds under its open market operations to infuse liquidity. In March, it introduced a new liquidity tool using long term forex swap auctions.
Narayan said the RBI should keep a wide set of liquidity tools available for use based on the situation. Each of these tools bring with them their own set of pros and cons.
Of all the options, I believe long-term repos of government bonds are the least intrusive into other markets. It impacts government bond yields the least, it impacts currency markets the least. That is the instrument which is most harmless.Ananth Narayan, Associate Professor of Finance, S.P. Jain Institute Of Management And Research
Sivakumar said apart from existing tools, the RBI needs to start accepting highly-rated corporate bonds as part of its liquidity adjustment facility window. Banks borrow from the RBI via this window by offering government bonds as collateral.
This should be extended to corporate bonds, said Sivakumar. It was suggested in 2016 by a RBI-appointed committee but is yet to be accepted.
The RBI can do repo operations with corporate bonds. Remember, in a repo operation, the RBI’s first risk is to the bank who is borrowing and only if the bank defaults do you need to worry about collateral value. So if you take good quality collateral at a reasonable haircut, you suddenly open up an entire new window of liquidity.R Sivakumar, Head (Fixed Income), Axis Mutual Fund