Covid-19 Response: Making Sense Of RBI’s Second Medicine Dose

The Reserve Bank of India governor announced a new set of measures in response to the current growth and financial market stress. These measures are mostly aimed at easing some pressures on the lower-rated/smaller participants of the financial markets. For the general bond and money markets, the major announcement pertains to a further widening of the liquidity adjustment facility corridor with the reverse repo rate being cut by a further 25 basis points to 3.75 percent. The repo rate—the mandate of the Monetary Policy Committee—and the marginal standing facility rate have been kept constant. The ways and means advance facility for states has been enhanced by 60 percent, instead of the 30 percent announced earlier, available till Sept. 30. Also, the liquidity coverage ratio has been temporarily reduced to 80 percent.

Other measures are as follows:

1. A new targeted long-term repo for Rs 50,000 crore has been announced directed at NBFCs. This has to be in investment-grade instruments and 50 percent has to be allocated to small and midsize NBFCs and microfinance institutions. The deployment has to be within one month and the investment can be under additional held-to-maturity, as before. Also, the exposure will not count under the large exposure framework.
2. All-India financial institutions NABARD, SIDBI, and NHB will get a cumulative special refinance facility for Rs 50,000 crore at the RBI’s repo rate.
3. Various asset classification relaxations have been provided, including standstill on the classification of accounts undergoing moratorium, between March 1 and May 31. However, banks will have to provide additional capital on the standstill accounts. Also importantly banks have been disallowed from making any dividend payments from profits pertaining to the financial year ended March 31, 2020, until further instructions.

Importantly, the governor has clearly indicated that all facilities are largely open-ended and can be enhanced as needed. He also provided the same assurance on overall RBI steps. Finally, he presented a benign analysis of the Consumer Price Index noting that it will likely settle below the target of 4 percent by the second half.

Assessment

The new measures are welcome and will serve to ease financial conditions on the margin. However, it is possible that the RBI is still somewhat underestimating the fact that the real problem, in our view, is that of inadequate availability of risk capital in the system. Thus, some of the “push” measures may likely have limited impact. As an example, banks may still hesitate to lend to weaker credits under the new TLTRO since the dispensation is on market risk and not credit risk. As another, while the lower reverse repo is a good push incentive, a more powerful one could have been general time-bound HTM relaxations for banks investment in government bonds.

Apart from the selective measures towards easing liquidity flow to various aspects of the economy—which anyway will also be a function of the risk perception of lenders—there’s a general pressure even in the quality part of the bond market. Thus, sovereign yields have been inching up for mid- to long-end bonds because, amidst general inadequate availability of risk capital, the deficit financing plan ahead is quite murky. So, while it is somewhat reasonable to expect at least a 400 basis point combined expansion in central plus state deficit, the absorption plan for this supply is as yet unannounced. To be fair to the RBI, it may be awaiting the actual announcement of borrowing to unveil the absorption plan. However, in another way, it seems to have largely abandoned its focus on the market channel of transmission for now. It may be recalled that the so-called Operation Twist had been devised to incentivise the market transmission channel – influence corporate bond yields via influencing government bond yields. The seeming apathy when this channel now lies broken, at a time when the country’s nominal GDP growth rate is collapsing further, is somewhat surprising. The general narrative has been that the quality borrowers have been cornering RBI’s liquidity.

Takeaways

The measures today are relatively small in terms of their impact on the quality part of the bond market. Their effect on lower-rated borrowers will depend upon the risk appetite of lenders as mentioned above. From an absolute risk versus reward perspective, front end (up to 5-year) quality bonds provide the best value. Long duration is quite attractive as well, both on term spreads as well as on gap from expected nominal GDP. However, its sustained performance will importantly depend upon the RBI unveiling a credible plan for financing the substantially expanded fiscal deficit in the year ahead.

Suyash Choudhary is Head – Fixed Income at IDFC AMC. This note was first published as an IDFC MF newsletter. Disclaimer

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.