The RBI has further tightened today measures taken last week as follows: 1. Access to repo window restricted for each bank at 0.5% of net demand and time liabilities (NDTL) for that bank. This is effective immediately. To recollect, RBI had last week restricted repo drawdown to 1% of NDTL or INR 75,000 crores. Although, the RBI hasn’t mentioned a number against this, the new limit will stand at INR 37,500 crores for the system as a whole. However, each bank will have to borrow within its own cap of 0.5% of NDTL. 2. Effective first day of next reporting fortnight (July 27th), banks will have to maintain minimum daily CRR at 99% of requirement. Minimum required was 70% so far. 3. Announced cash management bill (CMB) of INR 6,000 crores to drain liquidity. Impact The intent of measures taken last week was to take overnight rates higher towards 10.25% (which is the new MSF penalty rate at which banks). However, the RBI chose to tighten liquidity via doing OMO sales to the market. Subsequently, the central bank failed to absorb enough under the OMO sales; supposedly because it did not want to sell securities at very ‘disruptive’ yields. Combined with cancellation of treasury bill auction, the net effect was in fact a liquidity injection last week rather than a withdrawal. Furthermore, seasonal paybacks from currency with public starting the current week would have ensured that the proposed rise in overnight rates would have got pushed back further. The steps taken today effectively ensure that overnight rates will set to 10.25% immediately. Market Takeaway The apparent lack of resolve seen by RBI in implementing its own measures announced last week was leading some to believe that the central bank perhaps has developed cold feet. Today’s measures will put those speculations to rest. On our part, we were hesitant to stand against the central bank intent and for that reason have continued to hold large cash levels. However, there are some key takeaways here that need to be highlighted: 1. The RBI has refrained from actually hiking CRR (there was some speculation in market with respect to this) in order to curtail liquidity further. It may be remembered that the central bank considers CRR as not merely a liquidity tool but also a signaling tool for monetary policy. The absence of a hike in CRR can be interpreted as reluctance in signaling a reversal in monetary policy stance. Therefore, while the RBI’s intent is very strong and will transmit sufficient pain to financial markets, there is no reason to believe that the measures are not temporary. Indeed, government officials of all levels have lately been at pains to point out the temporariness of this measures (thereby potentially diluting the expectation effect of these measures). However, at this time it is risky to call just how temporary these measures can be. 2. With today’s measures the likelihood of OMO sales in the future has gone down considerably. This is important as OMO sales would not only have tightened liquidity but also created additional supply for bond markets to absorb. Besides, GOI has shortened maturity of its auctions this week (which will presumably also happen for next few auctions). Thus weekly supply of the long end of the curve has been reduced from INR 6,000 crores to INR 3,000 crores. 3. There has been a lot of chatter from policy circles lately with respect to a NRE/sovereign bond issuance. This is part of a logical 2 –step process where RBI measures first try and stabilize the INR which gets followed subsequently by an announcement that gets us dollar flows (NRE/sovereign bond). 4. As we have mentioned before, the longer the current measures stay in place the more the ultimate impact on an already weak growth environment. While as we have argued before, aggressive rate cuts were never the answer to restore economic growth in this cycle, it is also true that a disruptive funding environment such as the one that RBI is engineering currently is bound to have a detrimental effect on growth. Given these, and as we mentioned in our last note (refer “RBI Measures and Investor Takeaways” dated 16th July), we believe that the current phase will throw up very attractive opportunities on the bond curve. It must be remembered that the single disruptive measure that the RBI has implemented is capping banks’ borrowing at the repo window. This has killed appetite from banks to buy government bonds and hence is yielding very large term spreads versus the repo rate. It is likely that over the next month or so these term spreads get even better. Now It is clear that the cap on repo borrowings cannot be a permanent measure and will be removed once the RBI deems the currency market to be stable (it may be recalled that the RBI has done exactly the reverse of this in the last cycle by capping reverse repo intake at a time when India was getting a surfeit of dollar liquidity and INR was appreciating very considerably). Once the cap is removed, banks will start buying government bonds again and it is likely that term spreads will compress from thereon. Meanwhile, bond valuations over the next few months will be attractive enough to absorb the macro-economic risks in the system; external and fiscal risks being the two large ones in our view. Considering the above, we would reiterate our view that investors should look to add to dynamic, income and gilt funds over the next few months. On our part we will look to gradually invest our cash over the time ahead. What needs to be remembered while doing this is that at this time it is almost impossible to call how ‘temporary’ these measures prove to be. It is likely that this fact may impart heightened volatility to near term returns. However, (finally) there is little doubt in our mind that bond valuations seen over the next few months will provide an attractive opportunity for investors with a one year plus time horizon.
Posted on: Wed, 24 Jul 2013 05:42:03 +0000