By: Punam Sharma
The RBI surprised all today by cutting repo by 50 bps to 6.75%. It has also given a medium term road-map for expanding FPI limits in government bonds. Thus FPI limit in central government securities Will be raised to 5% of outstanding stock and in state government securities to 2% of outstanding stock by March 2018. This will open up INR 1,20,000 crores and INR 50,000 crores respectively in central and state government securities, to be distributed evenly across quarters starting the October quarter. Furthermore, banks’ HTM limits are to be rationalized to 21.5% in line with SLR ratio starting the fortnight of 9th January 2016. Thereafter both ratios will be cut by 25 bps per quarter till March 2017.
Instead of focusing on verbatim commentary, we are instead laying out our broad impressions from the policy. The takeaways embedded are very important in our view:
1. The biggest driver of the move today seems to be a recognition of the marked deterioration in the global outlook for growth and its possible feedback loop to India. There are specific worries around weakening growth prospects in emerging market economies (EMEs) and the fall in world trade volume growth below world GDP growth. This fits well with our own analysis of the global and local macro environment as detailed in our note “The Seven Year Itch…And Investment Implications”, dated 2nd September. Given that India no longer runs an external funding risk (our CAD plus net FDI is now a positive number), the central bank had the luxury to respond to the growth risks without worrying about excessive currency volatility. Indeed, the rupee has strengthened post the rate cut.
2. There is clearly a sense of greater co-ordination with the government that comes out. This is most apparent in the RBI’s future inflation assessment which shows an average of 5.5% in FY 17, moderating to 4.8% in Q4 of FY17. This is a strong reaffirmation of government’s food price management as well as the future fiscal stance, alongside an embedded view of a prolonged global commodity price slump. What we find particularly encouraging is the prognosis for the future fiscal stance since the next year will have to incorporate a rise in revenue spending on account of the 7th Pay Commission as well as from the recent One Rank One Pension. Importantly, the RBI caveats these spending risks by saying that the government has reaffirmed its desire to respect its fiscal targets and improve the quality of its spending. The increased co-ordination between the government and the RBI is further affirmed by the press conference done by the finance minister just after this policy as well as both committing to work towards improving transmission of rate cuts.
3. The RBI continues to be flexible with the ‘real rate’ framework. This had started as a 1.5 – 2% real rate ‘target’ of repo over CPI. It evolved to the same real rate applying to what a 1 – 1.5 year saver would earn (presumably the fixed deposit rate for that tenor). In between there was also some reference to tax adjusted returns to savers. It seems to have finally settled on the 1 year treasury bill as being the anchor. Thus at 5.5% average inflation forecast for the year ahead and assuming a 1.5% real rate target, Rajan is quite rightly assuming that 1 year treasury bill rate will settle around 7% with a repo rate of 6.75%. Thus, he is maintaining his real rate band while also signaling that policy rates may be on hold for some time. This is further reaffirmed by him saying that the policy focus will shift towards ensuring transmission into lending rates.
4. However, importantly, the policy is still accommodative and open ended (unlike a ‘hawkish’ cut that some were expecting) and there still may be more easing ahead over the course of the next year. The most likely trigger for this easing could be a further deterioration in global growth and trade prospects and / or CPI undershooting RBI’s average forecast of 5.5% for the year ahead. For the record, the total inflation ‘build-up’ in FY 15 was 5.16% (build up refers to the sum of month on month changes for the whole year and better reflects actual inflation since it completely strips out base effects). In the current financial year, we are so far tracking 71% of the FY15 build up. So there may be room to undershoot the average forecast of 5.5% that RBI has put out for FY 17.
At the time of writing, the 15 year actively traded government bond is still dealing 100 bps over the repo rate of 6.75%. This is an attractive term spread given two things:
- Policy still remains open ended even though there may be a near term pause. We have repeatedly pushed against a ‘closed ended’ rates framework given the unusual level of global growth uncertainties and the fact that local policy response to inflationary pressures have been continually evolving. The same holds even now, especially in light of the recent further turndown in global growth prospects.
- The increase in FPI limits will ensure that an additional source of demand for SLR assets to the tune of approximately 10% of additional supply emerges over the next 2.5 years. This further improves the demand –supply dynamic over this time period.
Given the above, we think long term bond investors should hold on to their asset allocation to active managed duration oriented products. We would hence reaffirm the portfolio themes we had detailed in our recent note “Portfolio Implications of This Long Macro Cycle”, dated 9th September.
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