MC Interview: Banks' appetite for bonds keeps markets concerned, says India Ratings' Soumyajit Niyogi

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The Reserve Bank of India has kept both the repo rate and reverse repo rate unchanged at 4 percent and 3.35 percent, respectively, and continued with its the so-called ‘accommodative’ stance in the backdrop of elevated levels of inflation.

The more-then-expected dovish stance of the central bank received good response from the markets, but the government's 10-year bond yields fell nearly 8 basis points to 6.75 percent on Thursday.

Soumyajit Niyogi, Associate Director, Core Analytical Group India Ratings and Research took Moneycontrol through various aspects of the RBI Monetary Policy Committee decision. Excerpts from the interaction:

Do you think the central bank surprised the market by keeping the key policy rates unchanged?

Market participants were largely convinced about a possible hike in reverse repo, which didn’t materialise. I believe yesterday's market action was short-lived. The hike in reverse repo just got delayed for the time being, it should come in the near future. And the short-term rates have calibrated to normalcy, therefore normalisation of reverse repo to repo corridor seems to be baked in pricing behaviour.

The market is more concerned about the supply pressure, given tailwinds like banks' appetite for bonds or OMO purchase are not envisaged. With the expectation of a much higher current account deficit (-2.3 percent) in FY23, compared to the last few years, in case the capital account turns negative, that could open up room for OMO purchase.

Is the RBI behind the curve in raising rates since they missed an opportunity on Thursday?

Whether the central bank is behind the curve or not it has become relative. The conclusion will vary if we go by the 4 percent inflation target or if we believe the upper band of 6 percent is the tolerance limit. Ideally, there shouldn’t be such a dilemma under the inflation targeting framework, but we have adopted a flexible inflation targeting framework along with multiple objectives.

In case tightening of monetary conditions in advanced economies gains more traction, adopting calibrated reactions by developing economies will be difficult. Therefore,  tacit normalisation will continue.

Why do you think the RBI increased the limit under Voluntary Retention Route for FPIs from Rs 1.5 trillion to Rs 2.5 trillion? Do you think it will pave the way for investments in sovereign bonds as well?

When the external condition is turning adverse, it is good to have stability in flows. Given the volatile interest rate environment, investors will have more flexibility to choose their investment strategy.

Do you see concern among market participants that inflation may escalate further since RBI refrained from raising rates?

The worry belongs to the classical impossible trinity. The central banks in advanced economies are turning more hawkish, the concern over inflation is more critical at the societal level for advanced economies. And drivers of inflation are no less worrisome, one is elevated commodity prices and another is sustained supply-side challenge.

For India, the impact of risk of crude oil price staying above $90/bbl  is high, along with the commodity price driven inflation. The corporate performance in terms of EBITDA margin or cash flow margin have been robust for the last two years.

It shows corporates have pricing power or in some cases absolute control over overhead cost, even though we are not sure about broad based recovery of aggregate demand.

That means in some sectors, due to lack of competition, corporates are in a position to pass on the entire input cost. They are trying to recoup in case they had any losses on profit due to COVID-19. These dynamics will not be resolved unless we see severe weakness in aggregate demand or supply start outpacing demand, both are improbable at this juncture.

With moderate demand at an aggregate level, producers will be less encouraged to go for normal, steady state capex at a larger scale, barring inorganic capex.

Do you think the RBI has done a good job on managing the surplus liquidity through VRR (variable repo rate) and VRRR (variable reverse repo rate) auction? Will this ensure that the yield curve is not disrupted?

Efficacy of long-term VRRR auction seems to be encouraging as it has mopped up excess liquidity in the system without permanent sterilisation. Thus, the changes in the nature of liquidity and normalisation of short-term rates, has alleviated the risk of large open market sells by the RBI that could have led to severe impact on yield. This has also reduced the risk of improper market activities owing to sustained low rates.

The excess liquidity in the banking system has turned marginally surplus on a daily basis, the remaining surplus amount has now been held under long-term VRRR. This is expected to bring back natural friction in the money market segment, which is healthy. It is an innovative way to steer liquidity without disrupting the G-Sec and other associated  markets.