The Reserve Bank of India, in what will go down in the annals of India’s monetary policy history as a watershed moment, announced a wide swathe of measures “warranted by the destructive force of the coronavirus. It is intended to (a) mitigate the negative effects of the virus; (b) revive growth; and above all, (c) preserve financial stability”.
While the municipal authorities are busy sensitising the people and sanitising public places to counter the spread of the virus, the RBI has, we believe, unleashed a Bazooka which fires multiple rounds in its attempt to sensitise the market participants to the reality that the central bank has the economic might to well and truly respond, and also to sanitise certain market segments which were getting impacted by the impact of the coronavirus.
The markets were demanding an emergency rate cut, liquidity measures, forbearance, and financial market support. There were way too many suggestions to heed from anyone and everyone.
Even then, the RBI seems to have delivered way more than anyone’s expectations.
As pointed to in an earlier column three months back, this RBI under Shaktikanta Das is bold and is also heading towards playing its part as a full-service central bank with multiple objectives and multiple targets with financial stability at its core.
I had also written last month on the caveats of bold monetary policy actions but no one, including me, will fret about it from the actions taken today. Today’s moves were required to safeguard and soften the impact of a health pandemic becoming a financial pandemic in the very short term.
Big Moves With The Primary Tools
There are some overwhelming actions that will have a significant impact, especially on corporate bonds, money markets and eventually on bank credit.
The move to reduce the reverse repo rate by a larger 90 basis points as against the repo rate cut of 75 basis points has widened the liquidity adjustment facility corridor to 40 basis points. Till 2012, RBI had used the width of this corridor to drive monetary policy and monetary transmission.
Given that the system liquidity is already deep in surplus, and now with the additional cash reserve ratio cut of 1 percent, the reverse repo rate now at 4 percent becomes the effective overnight rate.
All market yields, be it the overnight rate, money market rates, corporate bonds, and government bonds will use the reverse repo rate as the base pricing for market fair valuation. This, in itself, will bring down term-spreads on these market instruments.
The cut in CRR by 1 percent should boost bank liquidity and also increase bank margins as they start earning interest on that amount, which will eventually get passed on to borrowers as lower lending rates or to the bond markets in lower money market and bond yields.
How The TLTRO Will Work
The real outside the box move, though, was the Targeted Long Term Repo Operations or TLTRO, whereby banks will be made to buy up to three-year corporate bonds. We had seen, in the last two weeks, a very sharp increase in market yields of even high=rated PSU corporate bonds indicative of market dislocation and risk.
This TLTRO will help get liquidity back into the corporate bond markets and will also lead to a fall in the short-term bond yields of AAA-rated corporates.
Some AAA PSU bonds of 2-5 year maturities have seen a fall in yields of 70-100 basis points at the time of writing. This intervention in the corporate bond markets is very rare in global monetary policy actions. Even the U.S. Federal Reserve only recently announced its intention to buy corporate bond ETFs.
The bond market is rejoicing, especially at the shorter end of the curve, with money market yields falling by more than 200 basis points, short-term PSU bond yields dropping by 50-100 basis points and short-term government bond yields falling by around 50 basis points. Meanwhile, long-term bond yields (10-year government and 10-year AAA PSUs) have seen a fall of only around 20-30 basis points, as the risk of fiscal slippage remains high and also because RBI is likely to use open market operations only tactically. We expect the bond yield curve to steepen, meaning the spread between the shorter-tenor bond yields and longer-tenor bond yields will increase.
What Else Is In Store?
The one other bold move not announced but not beyond the realm of the RBI’s actions, is to directly buy government bonds from the government to fund the increase in the fiscal deficit due to the announcements made on March 26. It is likely and may be used in case of the bond market’s inability to absorb the extra supply which will start from April at the current lower yields.
Despite all this, we continue to advise investors in debt funds to choose funds that focus on keeping credit risks low and have liquid portfolios. India entered the Covid-199 pandemic with a weak economic background and the impact of the outbreak on companies and the economy is likely to be severe, depending on how long the lockdown continues.
The overall situation remains uncertain and despite these overwhelming measures by the RBI, we also expect markets to remain volatile. As an investor, if you are uncomfortable with market volatility in these times, we would even advise you to choose a safe bank deposit to park your money.
Arvind Chari is Head - Fixed Income & Alternatives at Quantum Advisors. Views expressed are personal. Disclaimer.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.
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