RBI OMOs distorting 10-year yield, says Chetan Ahya

Chetan Ahya, MD of Morgan Stanley says the bond market movement in the last few days has been distorted by the fact that Reserve Bank of India (RBI) has to inject liquidity through open market operations (OMOs), buying long bond paper. Ideally, he says, RBI should have been buying short end paper. But since there is not enough liquidity, RBI tends to buy the long-end paper and that distorts the bond yield.

Bond yields have softened to below 8 percent and that has given a lift to the banking stocks. "With the underlying fundamentals of the macro in the way the fiscal deficit is likely to be, we don't really think that this yield fall was really justified," he told CNBC-TV18 in an interview. On the market's expectation of repo rate cut, Ahya says everybody is expecting a 25 bps rate cut on January 29 and 75 basis points cut for the year. He says the scope for aggressive rate cuts will be limited due to the twin deficits. The current account deficit—the difference between import and exports of goods and services—in the second quarter of the current fiscal (July-September 2012) reached an alarming level of 5.4 percent of the gross domestic product (GDP), while fiscal deficit reported to have touched 80 percent of the full year target by the end of November. Ahya says the high current account deficit is likely to weigh on the rupee. "I think rupee is likely to depreciate significantly in case of a risk aversion," he says. In this backdrop, Ahya says he is not expecting the government to present a populist Budget this year. Below is an edited transcript of Chetan Ahya's interview on CNBC-TV18. Q: Are you pricing in or putting in a 25 basis points (bps) cut in repo on the 29th January? A: I would separate market's expectations on repo rate from the bond market movement because this particular bond market movement in the last few days has been distorted  by the fact that Reserve Bank of India (RBI) has to inject liquidity through open market operations (OMOs), buying long bond paper. Ideally RBI should have been buying short end paper. But since there is not enough liquidity, RBI tends to buy the long end paper and that distorts the bond yield. With the underlying fundamentals of the macro in the way the fiscal deficit is likely to be - we do not think that this yield fall was really justified. As far as the second question, on the market's expectation of repo rate cut, I would say from what we are understanding by discussing with the investors, we think everybody is expecting a 25 bps rate cut on January 29th. Q: What is the prognosis on how the yields will pan out from here; do you see them continue to trade below 8 percent levels? A: I think this yield would probably be protected that way because RBI will have to do OMO until March. We expect loan deposit ratio to continue to rise and liquidity conditions to be quite tight right up to March. Even after the government starts spending the gap between credit growth and deposit growth will keep that loan-to-deposit ratio (LDR) ratio in a tight position and therefore RBI will keep doing OMOs and that would support the bond yields. Q: There has been lot of talk in the environment about how inflation might start cooling down quite rapidly March-April onwards and now because of weather factors food inflation might already be on the way down. Do you think we could get 100 bps this year in terms of rate cuts? A: We are expecting about 75 bps cut in 2013 and that is lower than what a lot of people are recently beginning to talk about because we still think that the problems on macro stability indicators will take a while to correct. As we got the latest current account deficit numbers, it was above 5 percent. We expect it to narrow going forward, but it will still remain at an elevated level at around 3.5-4 percent. Similarly while Wholesale Price Index (WPI) inflation may have started to moderate, the Consumer Price Index (CPI) is still at 10 percent. With these two macro stability indicators not giving adequate comfort, we think that the scope for doing an aggressive rate cuts is still not going to be there. Q: Talking about rupee, there is a concern that foreign institutional investor (FII) inflows this year may not be as strong as the year gone by. In case of a phase of risk aversion do you see significant downside to the currency? A: Whenever there will be risk aversion over the next 12 months, we will see big depreciation of exchange rates. The current account deficit will be quite high. So we will need capital inflows to continue and the global market to support it. However, one must understand that we have seen two big central banks actions. First we saw from the US and then from the European Central Bank (ECB) and they have been able to take away the systematic risks from the markets. So, in that sense one would expect that the capital inflows should be supportive in 2013. So the probability of a major risk aversion should be low but if risk aversion were to occur, I would say that the rupee will depreciate significantly. Q: Focus is slowly building up on what kind of Budget we may find this time around and that will probably also hold the key to how markets move in the next couple of months. From a market perspective where would you set your expectations for on 28th February this time? A: On the day of the Budget, I would be very surprised if the Budget is being shown as a populist Budget. I do not see any upside of doing it. If they were to actually spend more before elections, I think it will be back-ended and so in that sense I think they will definitely show lower fiscal deficit and probably even likely try to manage a lower fiscal deficit because now the books are open. We are no more in that illusion phase that fiscal deficit does not matter and it is good for the economy. We have seen time and again all the analysis from everybody, including RBI, showing that fiscal deficit is the key reason why we have current account deficit at such a high level and fiscal deficit is the key reason why we have inflation at high level. So I think it is clear to them and as politicians and policymakers, it would be in their own political interest to have inflation coming down before general elections. Q: What about the US economy. What is the feedback from your US team with regards to the fiscal cliff resolution and with debt ceiling negotiations? A: I think the big risk has been averted and according to our team even with this deal with the Republicans, there is still going to be about 1.5 percent fiscal tightening in 2013 and that will lead to subtraction of 75 bps of gross domestic product (GDP) growth in US. As a result they are expecting GDP growth at 1.4 percent in 2013 versus 2.2 percent in 2012. So they are still seeing fiscal tightening. By all these agreements that they are doing, it does not mean that there is no fiscal tightening. We will still see fiscal tightening. It is just that we have averted the big cliff of potentially about 5 percent fiscal tightening.