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  1. Economic Outlook: RBI’s open market operations to cool yields

Economic Outlook: RBI’s open market operations to cool yields

RBI has finally decided to do an open market operation (OMO) purchase to cool yields. We continue to expect policy makers to further try to comfort sentiment in the G-sec market.

By: | Published: May 15, 2018 4:47 AM
RBI Monetary Policy, Bonds, RBI, consumer price index, CPI, house rent allowance, HRA, Standard Chartered Bank Our balance of payments (BoP) projections halve RBI foreign exchange (FX) intervention to billion (at our /bbl forecast for crude prices) from FY18.

RBI has finally decided to do an open market operation (OMO) purchase to cool yields. We continue to expect policy makers to further try to comfort sentiment in the G-sec market. After all, the 125 bp yield spike since the last RBI rate cut in August 2017 is pushing up lending rates to delay recovery. The May 4 announcement strengthens our call that RBI OMO will push the government securities (G-Sec) market into excess demand in FY19, a la 2016, with rising oil prices and weaker portfolio flows limiting RBI’s foreign exchange intervention. Our liquidity model estimates that RBI will need to inject $37 billion of reserve money/ durable liquidity in FY19.

Our balance of payments (BoP) projections halve RBI foreign exchange (FX) intervention to $15 billion (at our $64/bbl forecast for crude prices) from FY18. This implies that RBI will have to make OMO buys of $22 billion (including ~$11 billion of the budgeted government buyback). This, in turn, will push the G-sec market into excess demand. On balance, we retain our forecast of a August 1 RBI rate-cut as we are now tracking April CPI inflation at 4.2%, a shade below March’s 4.3%.

We continue to believe macro risks are overdone in the G-sec market:

  • Our liquidity model estimates that RBI will need to inject reserve money/durable liquidity of about $37 billion in FY19 to sustain 6% old series GDP growth. It supplied our $30 billion forecast last year.
  • Our BoP forecasts see FX intervention almost halving to $15 billion in FY19 on higher oil prices and lower foreign flows. This assumes our $64/ bbl oil price forecast. $10/bbl impacts the current account deficit by $9 billion. If oil persists at the current $75/bbl, RBI may have to sell, say, $5 billion of FX.
  • RBI will have to supply the balance liquidity of $22 billion through OMO purchases and government buybacks (~$11 billion budgeted).
  • This, in turn, should push the G-sec market into excess demand.

Food inflation continues to come off even in May. With inflation peaking off, RBI MPC should overlook the jump in June inflation to 5% levels on base effects. With our estimate of FY19 CPI averaging at 4.3% (ex base effects), we think that the RBI MPC’s inflation risks are overdone:

  • Budget FY19’s MSP hikes: Limited inflation impact as the revised MSPs still below market prices in most crops.
  • HRA revision by states: Unlikely to be significant, just as the Centre’s wasn’t.
  • Fiscal slippage: We ourselves see 20bp in FY19 (3.5% of GDP). This can hardly be inflationary when capacity utilisation is languishing at 74%.
  • Monsoons: The Met has forecast a good monsoon, at 97% of normal.
  • Volatile crude oil prices: Our oil strategists see Brent at $62/bbl by December. Delhi has reportedly asked OMCs to absorb `1/L hike instead of raising prices for the consumers in a pre-election year.

Co-authored with Aastha Gudwani, India economist, BofAML Exerpted from BofAML’s India Economic Watch report, May 7

The author is Co-head and economist, India Research Bank of America Merrill Lynch

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