By: Punam Sharma
The RBI announced INR 40,000 crores of Open Market Operations (OMO) purchases for November, after having done INR 36,000 crores in October. Prior to this it had done INR 20,000 crores in September, and INR 10,000 crores monthly between May – July. This is largely in line with the two pillars of our core fixed income view: A shallow rate hike cycle; and large scale OMO purchases to partly compensate for an aggressive core liquidity deficit expected in the current financial year. The following points need reiteration given the OMO announcement and other goings-on recently:
1. There seems to have been more aggressive intervention from RBI in the forex market in October. This has correspondingly increased the projection on core deficit calculation and by implication for OMOs. By our estimate, core liquidity is still deficit approximately INR 50,000 crores as at date. Thus the OMOs announced for November will still largely only suffice to neutralize the current deficit without plugging any of the future leakage. Going by currency in circulation (CIC) trends just pre-demonetization and adding some nominal growth to it, one is looking at another approximately INR 175,000 crores currency leakage from here to March. Therefore, one should expect a steady pace of OMOs to continue over the rest of the financial year, even assuming that the RBI ultimately chooses to keep core liquidity in some deficit. If new sources of liquidity (forex via NRI deposit for instance) or new tools (long term repo, although ineffective in our view since this liquidity deficit is of a permanent and not temporary nature) come about, then the quantum of OMOs can be lesser. Reflecting the different demand – supply dynamics for government bonds owing to OMOs, as well as recent preference for liquidity, spreads on AAA quality bonds have risen to almost 100 bps over equivalent government bonds at parts of the yield curve.
2. Our view for some time has been that peak growth is past us. This view has largely been owing to the synchronized global recovery theme breaking down this year with consequent slowdown in export cycles, as well as due to a rapid tightening in local financial conditions. The tightening in financial conditions will get further accentuated with the recent wobble in NBFC / HFCs. This incremental tightening in financial conditions is owing to rise in credit spreads and possible liquidity hoarding, even as quality rates have rallied and rupee has been more stable. These new developments may have further repercussions on growth as there may be some slowdown in aggregate lending, even if banks step in to compensate for slowdown in disbursements from NBFC / HFCs. For MPC, this implies that their current assessment that output gap has closed may change down the line. This may impart more patience even if food prices start rising from their current unsustainably low levels. For RBI, this means further efforts in pushing against excessively tight financial conditions. From a market standpoint, both these imply that an overweight stance on quality assets at the front end (sovereign / AAA up to 5 years) continues to make a lot of sense.
3. Fiscal risks are becoming significant with a continued shortfall in GST collections, and on possible overflows on expenditure items like fuel subsidy. Also, capital receipts need to get off the ground meaningfully, and face additional headwinds owing to a potential weaker capital market. Slowing growth may also impact tax collections down the line. All told, there is risk of almost a 0.5% of GDP on the fiscal deficit target. However, there are two distinctions to be made here: One, a ‘cash accounting’ budget allows for some ‘compression’ in deficit by delaying spending and up-fronting collection of some receivables. Hence, it is entirely possible that most of this potential slippage doesn’t feed into actual slippage. Two, even if there is some minor slippage acknowledged it may not necessarily translate into extra borrowing in dated government bonds and may get absorbed into other sources of financing including short term instruments, cash drawdown, or accretion from small savings. For now, it is enough to acknowledge this risk (and hence restrict exposures to front end and not chase long duration, save tactically if at all), and be aware that if growth were to slow or bond yields to fall meaningfully, the temptation to admit to the slippage may be that much more.
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