Stubborn bond yields: How RBI can reduce cost of capital

Below is the transcript of the interview on CNBC-TV18.

Q: Before I start with the liquidity question which is really important for me, just one customary interest rate question. Last time in September, the governor actually surprised with a 50 basis point cut because the global growth picture had completely broken down. It has broken down again. Is there just a small chance that the governor may give a rate cut before the Budget?

Ghosh: There could be both a yes and no to this question. I do not think the governor is going to surprise with a rate cut in this February 2, policy because he just wants to wait for the Budget on February 29. But, the other aspect is that after the Budget, he may actually surprise the market with a bigger dose of rate cut. So, there is both the possibilities which are now on the table.

Q: A bigger dose after the fiscal deficit is known. Largely just about all the economists we polled are in line with what Soumya is saying and your report also said much the same. So, what then will you look forward in the monetary policy? What is the key message?

Chinoy: For the next monetary policy, the most important thing is to assess where the inflation glide path for 2016 is. Remember, in December, the RBI stuck to its September forecast which had inflation dipping just below 5 percent, 4.8 percent in the first quarter of 2017 because any monetary easing in the coming months has to be predicated primarily on inflation tracking below 5 percent. Now, a lot has changed between December and now.  The first is oil prices are down another 25 percent and the RBI estimates with every USD 10 reduction in oil prices, disinflates by in between 20 and 30 basis points in terms of the consumer price index (CPI). However, in India’s case, things could be different because much of that surplus has been captured by the government.  The second change has been the rupee. Back in September, the RBI’s forecast was predicated on a flat rupee. We have seen a 4 percent depreciation since then and you could see more depreciation going forward.  And third are fiscal and growth uncertainties. There is a chance now that the fiscal deficit could be relaxed and there is a downside risk to growth this year. So, there are so many moving pieces that I would look most closely at. If you put all of these things together in the last three months, what does that do for the RBI’s inflation trajectory? Are we now tracking much lower than 5 percent in the first quarter of 2017? What is average inflation which was pegged at 5.5? Has that come down because that will be, for me, the big give-away in how much space the RBI thinks is possible to cut in 2016.  And finally, I will say pay close attention to the weightage they have put on the fiscal deficit both on how important it is to stick to the fiscal consolidation path, how they would react to any relaxation, but also on the composition. Will the Pay Commission be implemented and what they think are the implications of inflation. So, even though we will not have a policy action, I agree with Soumya, there is too much uncertainty, there will be a lot of other stuff to look at in the policy review. Q: You will be the most important expert I want to hear simply because 125 basis points has not meant anything by way of yield dips in the market itself and the tenure is an important benchmark. You may take us through the other yields and point out if there is a meaningful dip in shorter-term paper. But, tell us what will you watch out for? Will it be more the liquidity signals that the RBI throws out?

Chopra: The biggest concern for the markets a little ahead of policy action clearly seems to be the extent of supply of government bonds. That in my view has been the single biggest factor which has sort of overwhelmed the market sentiment. So clearly, RBI needs to send out a signal in terms of the kind of open market operation that it will carry out, even this huge supply which we will see, not only of central government securities, but also of state government bonds. So, you are actually going to see a fair amount of supply of sovereign bonds and state bonds, even over the next two months, leaving aside the expected supply in the next financial year. 

So, in that backdrop, clearly, the RBI needs to soothe market sentiments in terms of at least sending a signal that they will not only look at providing liquidity, but also look at sucking out some of that supply because the current demand is just not sufficient to really absorb the kind of supply which we are going to see. Q: If you looked at the creation of high powered money, then that is still running at – or M3 itself – is still running at 11.3 percent. Normally, it should be in pace with the nominal gross domestic product (GDP). This is still running at the budgeted nominal GDP. Is the RBI really guilty of not doing open market operations (OMO)? Whatever he economy needs arithmetically, apparently has been done, would you say?

Ghosh: I just want to highlight one point over here. If you look into the high powered money components, it is two components. One is the net domestic assets (NDA) part and one the net foreign assets (NFA) part. Now, these high powered money component, a large part of these component is also through the auctions, the 28-day auctions, the 14-day term-repo which is taken into consideration where they are calculating the reserve money expansion.

Now, the difference between an OMO and this term-repo is that OMO is actually permanent liquidity injection while the other one is temporary liquidity injection. That goes out of the system. So, from that point of view, 11.3 percent could look a lot healthier. But, if you actually strip out that 14-day and 28-day term-repo impact, the reserve money growth may not be in consonance. 

And let me also point out a fact over here. As you know, this year, the total foreign exchange accretion has significantly declined by around three billion. So, even after appreciating that the reserve money maybe growing by 11 percent or so, I think we also need to take into fact the consonance that there has been a significant depreciation in NFA and there has to be some amount of conformity concomitant injection to the NDA to balance out the growth in the reserve money.

Q: Sajjid, your comment on the same point. Does the RBI need to do some kind of quantitative method, either buying more bonds or even cash reserve ratio (CRR) cut to ensure more transmission?

Chinoy: I do not think so, because we need to get away from this notion of financial repression which is that the RBI should not be monetising the fiscal deficit in the primary market and the RBI should similarly, not be providing some ceiling to yields in the secondary market by doing OMOs for the sake of doing OMOs, to protect any level of the yield. I completely agree with you that there will be base money targets that they have in mind given what their expectation of normal GDP is and that will be a function in the next year of what their balance of payments (BOP) surplus is because the more base money you create through intervention the foreign exchange markets, the less you have to do. 

So, there will be that balance the RBI keeps. But, should the RBI go beyond that remit just because the 10-year bond is at a certain level? I think that will be just accentuating the financial repression. Let us not hide from the basic fact here that the reason the yield curve is so steep is that India still runs a very large fiscal deficit. If you add the centre and the states are looking upwards of 6.5 percent of GDP, number one. And number two, over the last year, banks who have basically been buying these government bonds because there is not too much credit growth opportunities, have become much more risk averse at the margin. Why have they become more risk averse, because now, with statutory liquidity requirements (SLR) coming down, a much larger fraction of their portfolio is in the mark to market book and they are exposed to interest rate risk and to the extent that they believe that we are coming towards the end of an interest rate cycle. They are less inclined to buy bonds.

So, these are actually important market signals that are going back to the government that we have to bring the fiscal deficit down both centre and state. Now, we have the Ujwal DISCOM Assurance Yojana (UDAY) bonds in time for the long-end yield to soften. That is ultimate signal. The more the RBI does OMOs for the sake of it, the more we are suppressing those much needed signals for fiscal consolidation in the coming years.

Q: You stirred the argument right by saying, this time around perhaps, it is liquidity that the market will really watch out for and not so much inflation signals. I think the inflation trajectory will also be important. But, what else will you actually look out for from the governor?

Chopra: Largely, this Budget from a rate perspective is going to be a non-event. I do not expect an announcement on that. But, I do expect the governor to highlight a lot of risk, especially on the external side. Clearly, the world has started on a very soft patch in terms of its growth outlook. We have seen revision from World Bank. China continues to be a worry. So, a lot of these risks will be highlighted and from a policy perspective, it is possibly going to happen well after the Budget. Q: On liquidity itself, what exactly will you watch out for? Chopra: I cannot think of any specific provision in the policy itself, but clearly, RBI has been stating in all its monetary policy statements that they would want to ensure adequate liquidity in the system and they have been doing that. Barring certain periods of time where the government has held on to very large balances and has created a bit of a spike in overnight rates, RBI has handled liquidity fairly well during the current financial year. Q: The prior periods, when the RBI was very generous with its OMOs in the period of 2012 and 2011, we ended up harvesting double digit inflation as well. So, do you think the RBI has too much of an elbow room for OMOs?  Ghosh: I agree with your point and Sajjid’s point to some extent that at the end of the day, the yields are remaining high and that is also to do with the state finances. And if I go by that logic, that if suppose there is no OMO in the market, the yields are going to stay at these high levels at least in the current fiscal, because right now, the problem is not with the centre’s fiscal deficit. The problem is actually lying in the state’s deficit. And if you add up all those DISCOM bonds, the next year, the total amount could be more than Rs nine lakh crore.

Now, coming back to the point of whether the OMO in the years of 2011, the inflation was at such high levels. The inflation levels started to rise in 2009-2010 and that was because of structural issues. And if you remember, in 2012, when the government actually overshot the fiscal deficit from 4.6 percent to 5.7 percent, the yields had spiked to 9 percent, the 10-year yields. And at that point, the repo rate was at 8.5 percent. After that, there was a systemic liquidity injection and the 10-year yield was actually brought down to 8.10 percent. 

So, what I am saying is that just to smoothen the market, because at these current scenario, the fiscal scenario, the state bond issue, this huge supply of government bonds outstripping the demand, the demand is also going to come down because the SLR is coming down, so the banks are not going to invest that amount of money in the government bonds. So, if you take all these factors into consideration, some sort of market, it could actually soothe the market sentiments and that is the downward movement in 10-year yield is absolutely necessary for the banks to transmit also. Otherwise that scope will become limited.

So, appreciating the fact that maybe the RBI may think that the OMO could not be the correct signal, but at the end of the day, they need to do that so as to give the signal to market that there has to be some sort of transmission also on the part of the banks.

Q: It is just that at this point in time, that might mean Rs 1 trillion. So, that is a little scary in terms of the amount of base money creation. But very quickly, we are now exactly 12 months from the January-March 2017 period where the RBI has set the target of 5 percent. What do you expect that number will be? Will the RBI be able to guide for a sub-5 percent, like they did in the monetary policy report?

Ghosh: The RBI has done a very commendable job in terms of dealing the inflationary expectation from the becoming generalised. For example, if you look at the core price numbers, the core-CPI inflation, that has nicely settled down to the level of 4.5 percent. So, the RBI so far has been able to guide the market very properly and I do not see any reason where the inflation number is going to be within the RBI level of 5 percent because as of now, apart from the pulses prices, all other vegetable prices seems to be well under control. So, the Central Bank and with the help of the rain Gods, the glide path could become more meaningful and operational into the next fiscal year also.

Q: Similar question to you. What do you expect the RBI fan chart to look like? My sense is that they have to give a 12 month forward inflation number. What do you expect them to forecast, and what is your own forecast?

Chinoy: Two quick things. They have already given a number which is sub-5 percent. You look at the September review, the average inflation for first quarter of this calendar year was 5.8 percent, the average inflation for the first quarter of 2017 is 4.8 percent and average across the year is 5.5 percent. So, already they have committed to a number which is below 5 percent. My suspicion is, if you add up the events in the last three or four months, in some, the forces are disinflationary. So, I expect that the indication will be that the first quarter of 2017, inflation continues to be under 5 percent. I will not be surprised if they signal downside risks to the 4.8 number. 

Very quickly, our own forecast is just below 5 percent for 2017, suggesting there is some room opening up for easing. And I will just make a quick point on the whole discussion on liquidity, the proof of the pudding is in the eating, to the fact that the overnight call rate has by and large, been very close to the repo rate for most of this year, would suggest that the banking sector has been infused with enough liquidity. If there was a systemic liquidity shortfall, you would have seen the overnight call rate diverge significantly and sustainably from the repo rate which has not been done. That is ultimately what you have to judge liquidity conditions by.