Upping its recent proactive stance on liquidity, RBI announced an even higher pace for open market operation (OMO) for the rest of the financial year. Thus, it increased the quantum for December by Rs 10,000 crore to Rs 50,000 crore. It also announced Rs 50,000 crore for January and guided that it will ‘consider similar quantum of OMO purchases until end of March 2019’.
Of course, relevant usual caveats around currency in circulation and forex operations have been given. It may be remembered that one of the key highlights of the December policy was Viral Acharya saying the increased frequency of OMOs may be required till March. At the time the market had assumed this to mean the Rs 40,000 crore announced OMOs for Dec-ember would get replicated over January to March. The current annou-ncement ups this by another Rs 10,000 crore per month for this period. If this revised pace indeed gets delivered, RBI would have bought a stag?ge?ring Rs 3,36,000 crore in FY19. It will total to more than 80 per cent of the net borrowing programme of the government for FY19.
There are a few important takeaways from the new OMO announcement:
*This displays full continuity in RBI policy with respect to monetary policy measures. Thus, it may be recalled that Urjit Patel and Acharya had continued recent history when choosing OMOs over CRR as the preferred tool for liquidity infusion. In fact, the question of CRR usage had been summarily dismissed in the post-policy conference calls in December. With a change in the governor, there was an expectation in some quarters (and fear in bond market) that the tool may get discussed again. But this stepped up pace of OMOs puts back to rest this speculation.
*This re-emphasises the commitment of RBI to achieve neutral core liquidity at the very least. Acharya had laid out the liquidity objective in some detail in the December policy. Thus, he had explained that RBI was guided by principle of managing system-wide liquidity. It is also the lender of last resort wherever needed, but he didn’t think that was required currently. This principle also seems to be getting preserved after the change in the governor, with possible sector level liquidity shortages potentially driving RBI to be even more proactive on system-wide liquidity.
*With this quantum of OMOs, the impact of minor supply deviation on government bonds owing to small potential fiscal slippages may well get masked. Although we think the actual run rate so far is tracking a slippage, it may still happen that no slippage is actually shown by deferring some spending items. Also, a small slippage may not necessarily translate into additional borrowing through dated securities. One can always levy a charge that RBI is incentivising slippages in some sense by taking out such large amounts of government bonds from the market. But this has to be looked at as an unintended cost of policy. There is little other option, given the ask on liquidity creation and given that RBI wants to retain the current CRR levels. We aren’t too sympathetic to the idea of longer-term repos. For one, currency in circulation is an annual phenomenon and will be a drag on core liquidity next year as well. Assuming the same RBI dividend to the government, the only other offset will be if balance of payment turns substantially positive and RBI buys those dollars and creates rupee liquidity. But it will not be prudent to take a view on this. Also, banks may be reluctant to lend forward temporary liquidity provided to them, even if the liquidity provided is of a somewhat longer-term.
The current rally seems to be getting treated with suspicion by most investors. The context is understandable, since the past year has seen a rapid rise in yields and mark-to-market losses. Also, just a few months back the general wisdom of the market was to expect successive further rate hikes. Also, potentially adding to suspicion is the fact that this staggering quantum of OMOs may be artificially holding down government bond yields. So this begs the question, what happens when those OMOs cease; possible at beginning of FY20? Against these concerns, one should keep the following points in mind:
*The 175 bps odd rise in yields between mid-2017 to September 2018 (taking 10-year government bond as benchmark) has been matched or surpassed only twice before in the last 10 years. Both those times were exceptional. The first was 2009, when the government responded to the global financial crisis with a huge deficit expansion and consequent large-scale excess borrowing. The second was 2013’s taper tantrum when India was running double digit CPI and almost 5 per cent current account deficit. It’s noteworthy that the current episode happened without any large macro imbalance in our system. This magnitude of volatility is a rare phenomenon and shouldn’t colour asset allocation decisions of investors.
*There is a global context also to the current bond rally. There is a case that the unsynchronised recovery the?me underway for most of 2018 may be giving way to a period of synchronised slowdown. The action from commodities and yields curves, as well as variety of economic data, seems to be suggesting as much. If this is the case, then there is a case for fundamental shifts in asset allocation tables in favour of qu?a?lity fixed income; rather th?an just looking at the current phase tactically. Thus, the rate cycle has peaked and RBI is more sensitive than any time in recent history towards provisioning of adequate liquidity. If the global context remains as it lately is, then from here to explicit easing is just one step ahead.
*The ‘OMO effect’ is most certainly impacting government bond yields. This is getting apparent in a large widening of AAA and SDL spread over government bonds. Thus as an example, AAA spread over corresponding government bond is around 100 bps at the 5-year point. To take another valuation metric, 5-year AAA to repo rate spread at between 175 – 200 bps is still attractively placed compared with its 5-year history. Thus the choice is more of which risk – reward point to participate in rather than ignoring altogether what may just be a sustainable turn in the environment for high quality fixed income allocations.
(The writer is head (fixed income) at IDFC Asset Management Company)