Monetary conditions have started to tighten once again, just three weeks after the Reserve Bank of India cut interest rates sharply and flooded the system with liquidity. Fears of fiscal slippage have meant that long term bond yields have risen and risk aversion has keep bank credit growth low.
This could prompt further action from the Reserve Bank of India.
Mark-To-Market Relief?
“The current constraint is not system liquidity, but the bank’s lack of appetite to take on duration risk,” wrote Sajjid Chinoy, chief India economist at JPMorgan in a note dated April 14. Chinoy explained that banks have been holding government bonds well in excess of the mandated statutory liquidity ratio. This exposes them to higher mark-to-market risks that come along with investing in longer duration bonds.
“One can glean this behavior in the divergence between credit growth and the slope of the yield curve over the last year, which suggests that despite weakening credit growth, banks have been unwilling to taking on any duration risk,” Chinoy wrote.
The hesitation to invest in longer duration bonds has only worsened in the current environment where the fiscal uncertainty has worsened.
One of the steps that policymakers could consider is granting temporary forbearance to banks on their mark-to-market (MTM) accounting, Chinoy suggests.
“This will incentivise banks to take on duration risk, improve secondary market liquidity which, in turn, should help curb volatility and attract more participation into the market,” he wrote. “This allowance may need to be made “ex ante” to create demand for government bonds so that financial conditions don’t unduly tighten and the government can borrow in a non-disruptive manner.”
WMA & Open Market Operations
JPMorgan sees enough room for the central bank to continue its open market operations, under which it buys and sells government bonds.
Growth in currency in circulation is expected to remain high as households hoard cash and cash transfers are used by the government to provide support. The RBI would likely need to purchase government bonds just to offset this increase in currency in circulation and maintain banking system liquidity at current levels. This presumes that there is no more forex intervention or long term repo operations.
Chinoy expects the currency in circulation increase in FY21 to be 1 percent of GDP. “So the projected OMO space is meaningful, even in the normal course of events.”
The central bank would need to calibrate the timing of these bond purchases in a way that they coincide with a period when credit growth starts to pick up. However, some purchases could be front-loaded “as a signaling mechanism.”
In order to provide support to states, the RBI could consider further enhancing the limit for ‘ways and means advances’, which has already been increased by 30 percent.
The near-term fiscal-monetary objective should simply be for the government to raise resources – crucial to win the health war and stabilize activity – in as least disruptive a manner as possible. This would allow pushing out of weightier questions – like what the eventual fiscal deficit will be and how it will be financed – to much later, when there is more resolution to multiple layers of uncertainty.Sajjid Chinoy, Chief India Economist, JPMorgan
The RBI may also need to consider further relief measures for non-bank lenders so that liquidity constraints don’t morph into solvency concerns. The flight to quality has meant that liquidity access for some of these lenders, which provide important last mile financing, has reduced.
“Given the highly asymmetric distribution of liquidity across the banking system, this would potentially necessitate the RBI broadening its repo operations to accept corporate paper with appropriate haircuts,” Chinoy said.
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