RBI could start withdrawing from its accommodative stance, albeit in a phased manner
Bond yields have risen past the 6.2% mark, having spiked 9 bps over the past week; on Tuesday, they closed at 6.227%, but eased to 6.207% on Wednesday. On Tuesday, RBI sought to soak up liquidity from the system at a much higher rate than anticipated; it withdrew liquidity through the 7-day variable reverse repo rate at 3.99%. That is 57 bps higher than the rate seen at the previous auction and just a shade lower than the key repo rate of 4%, and has given rise to apprehensions RBI could move to normalise its accommodative policy earlier than expected.
Bonds had rallied in early Tuesday trade after the government decided to borrow just Rs 5.03 lakh crore in the second half of the year, and no additional borrowing was announced. This takes into account the funds needed to compensate states for a GST-revenue shortfall.
However, the rise in US treasury yields and the spurt in crude oil prices have convinced the bond market RBI may not be able to let go of its accommodative stance earlier than it might have wanted to. There is now speculation the central bank could raise the reverse repo rate at the forthcoming monetary policy announcement on October 8. The change in the tone at the August monetary policy may have been a slight one, but the statement did signal a change in approach. By opting to drain out some excess liquidity, Governor Shaktikanta Das took what could be called the second step to normalisation; the first was the central bank’s tolerance for higher yields at the July auctions of government paper. The central bank also doubled the quantum of liquidity to be pulled out, to Rs 4 lakh crore; at the time, bond market watchers had predicted we could be looking at a yield of 6.4-6.5% on the benchmark by the end of the year. That seems possible and should not be of much concern.
Retail inflation topped 6% in May and June—6.3% and 6.26%, respectively—above RBI’s tolerance band of 4-6%. It eased to 5.59% and 5.3% in July and August, respectively. Soaring crude oil prices, which filter through into local prices of auto fuels, are threatening to stoke a fresh round of inflationary pressures. The price of Brent slipped a tad to $78 on Wednesday, but it is slated to head upwards, even to $90/barrel. Meanwhile, US Treasury yields have been rising; at the last US Federal Reserve meeting, chair Enoch Powell sounded a shade hawkish; tapering is likely to begin sooner than expected and the withdrawal of the asset purchases of $120 billion per month could conclude by mid-2022. That is not too far away. Indeed, although the Fed stopped short of setting a date, the market’s guessing the purchases could be slowed as early as November.
It is just as well the Centre has reined in its borrowings; there was talk it might pick up Rs 1.6 lakh crore to compensate the states. Given how revenue collections have been robust, the fiscal deficit for FY22 could be contained well within the targeted 6.8% of GDP though we could see a shortfall in non-tax receipts. While that is good, the government must continue to spend to keep the recovery alive. It had been somewhat conservative so far, but, last week, curbs on expenditure were lifted for several departments. That’s the way to go.