India’s macros need more Operation Twists to breathe freely

Mahendra Jajoo

Something unusual happened last week. The Reserve Bank (RBI) announced a special open market operation where it proposed to buy long-term bonds for Rs 10,000 crore from the market while at the same time offering to sell an equivalent amount of short-term bonds maturing in 2020.

Market participants are popularly referring to it as an equivalent of the US Fed's ‘Operation Twist’. Now, it helps at this stage to understand what this term stands for.

Post the global financial crisis in 2008, the US Fed started buying long term bonds from the open market to help bring their rates down. This was commonly referred to as twisting the yield curve by the sheer force of its humongous buying volume.

The result? The US 10-year government bond yield fell from nearly 4 percent at the start of 2008 to almost 1.5 percent by the end of 2011 or so. Thus, that operation was hugely successful in helping the US economy recover from the abyss to even now, maintaining a reasonable GDP growth rate of around 2 percent.

Now, let us review the current macroeconomic environment. Globally, after the initial hat-trick of insurance cuts, the Federal Reserve seems to be in a prolonged pause mode. With injection of massive liquidity through the repo route, some believe that a de-facto fresh round of quantitative easing has started again in the US.

Other major global central banks seem to be on hold as well following the Fed, despite the disappointing growth outlook the world over except in the US where incoming data seems to suggest a reasonable growth momentum. The recent announcement of a phase-1 trade deal between the US and China has led to a fresh round of risk-on buying, with equities markets both in the US and India hitting fresh all-time highs. This may lead to some revival in inflation in global economy.

The silver lining is that given disappointing global growth outlook, any tightening by global central banks remains off the table, creating elbow room for the RBI to maintain an accommodative monetary policy stance even in the face of strong macro headwinds.

Domestically, GDP growth at 4.5 percent for July-September of 2019, the lowest since the shocking taper tantrum in 2013, is extremely disappointing with no realistic visibility of any early revival. But a modest cyclical recovery can be hoped for in 2020 supported by fiscal stimulus, credit pick-up, recent uptick in inflation led by agricultural price improvement and an easy monetary policy.

The macro headwinds remain strong with rising inflation, fiscal challenge and a widening current account deficit. Tax revenue collection remains well behind the Budget estimates. Even though the government may limit fiscal slippage in the current year with a higher RBI dividend, aggressive disinvestment, higher allocation from small savings and other off balance-sheet borrowings, the outlook for 2020-21 would be rather worrying on the fiscal front, especially until a clear trend of GST revenue growth is not established.

GST mop-up till October 2019 at Rs 3.44 lakh crore is just 51.9 percent of Budget estimates. Direct tax collections likewise stand at Rs 5.17 lakh crore, 38.7 percent of budgetary estimates. Thus, indirect and direct tax collections need to grow at 39 percent and 30.7 percent, respectively, for the remaining 5 months of FY20 as against the actual growth rate of -0.3 percent and 3.5 percent, respectively, for the first 7 months. That seems a tall order.

Inflation has raised its ugly head in recent months. The November print read 5.54 percent, from a mere 3.15 percent in July, due to aggressive revival in agricultural commodity prices. Even as most analysts bank on a quick reversal on fresh crop arrival, past experience suggests that it may take up to 6 months for inflation to moderate.

The outlook for monsoon for the next year is very crucial, on which no forecast can be made with any reasonable confidence at this point. Brent crude price bounced by nearly 10 percent in December 2019 alone to $66+ per barrel following a second round of production cut agreement by the OPEC (Organization of the Petroleum Exporting Countries). So far, in 2019, any sharp jump in oil prices including the one following the drone attack on Saudi production facilities has failed to sustain. With slowing global demand and shale oil surplus, that positive should prevail at the margin. Liquidity outlook remains benign with all hints of a continued positive outlook by FPIs on India.

Towards Q4 of 2019, despite a highly accommodative RBI, the benchmark 10-year yield flirted with 6.75 percent on mounting concerns of a large fiscal slippage due to poor tax collections, which are way off the Budget estimates. A significant cut in corporate tax rate to support revival in growth further added to concern.

Around the same time, headline inflation based on consumer price index (CPI) spiked to 5.54 percent in November, from a mere 3.15 percent in July, forcing the RBI to hold rates in its December policy. This sparked strong adverse reaction at the long end, with the 10-year yield hardening to 6.80 percent.

Rising yields would have adversely affected the cost of capital for borrowers, further dampening the growth momentum. Thus, market participants have for some time been arguing for an Operation Twist-styled action. Now, how effective would this action prove to be, going forward? Immediately after the announcement, the benchmark yield fell sharply by about 15 bps (basis points) to 6.60 percent. One percentage is 100 basis points.

The key is a series of such purchase auctions by the central bank. There is a reason to believe that would be the case. Thus, at the minimum, the Operation Twist would help cap the current rise in yields.

As expected, if the RBI continues to conduct a series of such auctions, the yield curve is expected to shift downwards, offering the much-needed relief to businesses with a reduction in cost of capital.

Mahendra Jajoo is Head of Fixed Income at Mirae Asset Global Investments (India). Views are personal.