By Rajeev Radhakrishnan
The version of Operation Twist announced by the RBI last week is one among the many unconventional actions with respect to the conduct of Monetary Policy pursued by RBI in recent times. In the August 19 policy review, the MPC announced a non-standard reduction of 35bps in the repo rate which was followed by an explicit forward guidance in the October review on keeping accommodative stance ‘as long as necessary’ for reviving growth. Despite forceful policy actions and forward guidance the transmission of policy rates has been sub-optimal, mitigating against the very purpose of policy rate actions and forward guidance. In the time since RBI cut policy rates in August 19, the long end bond yields (9-14yr) had moved up by about 30 bps prior to the December Policy review. Worryingly, in an environment of easy liquidity, the term premiums in the sovereign bond markets have remained elevated. While credit market issues have kept credit spreads elevated, the lack of transmission in sovereign markets, in an environment where economic growth impulses remain muted warranted urgent attention. Subsequent to the policy review in December, where the MPC kept rates on hold, the sovereign curve had shifted upwards by about another 35-40 bps.
The decision to announce a twist operation, with simultaneous sales of shorter dated securities and purchase of the benchmark 10-yr bond clearly points to an attempt to arrest the unidirectional upward move in bond yields. Perhaps, RBI may also be mindful of the potential fiscal spillover in the current year and any additional fiscal measures that may be announced in the forthcoming Budget. Notwithstanding the immediate reasons, the significance of the announcement lies in the fact that given the current growth inflation dynamics and the policy stance, the current term structure of the sovereign curve is inconsistent with the stance and objectives of the policy stance.
With the sovereign yields remaining elevated with an upwards bias, the transmission of rate cuts into the broader market segments get impeded as most credits are priced of the sovereign benchmarks. With the government owned PSU’s being the larger borrowers in the market, even extra budgetary borrowings would feel the impact of rising yields. While market concerns with respect to the fiscal stance remain the proximate cause, in the current environment, unconventional and forceful actions were necessary. At the same time, the willingness of RBI to follow through would be watched as regards the durability of the down move in yields.
From a technical perspective, the stock of short-term bonds in the BI holdings would constrain larger interventions. At the same time, if RBI decides to follow up through twist operations further up the curve beyond 2020 maturities, the possibility of a bearish curve flattening cannot be ruled out. In the context of external benchmarking of bank loans, the impact of the same needs to be considered.
Given that lack of policy rate transmission, especially in the loan markets have been one of the major addressable issues for RBI, it remains to be seen how RBI addresses the same. Impounding surplus liquidity generated through OMO purchases of long bonds through issuances of Market Stabilisation Scheme bonds could have been an option. However, given the present state of government finances, it remains unlikely that the same would be resorted to. In this context, creation of a Standing Deposit Facility (with auction determined rates) or the provision of central bank bills/bonds could be longer term options, especially as RBI seeks to arm itself with tools for potential similar unconventional measures.
While RBI has rightly stayed away from unconventional policy actions similar to those followed by global central banks, which have had a distortionary impact on asset markets, unconventional policy measures to the extent of targeted communication, explicit guidance, as well as specific interventions in the markets, were warranted in the current context. Over the longer term, the fundamental issue remains the demand-supply mismatch evident in the government bond markets in the absence of RBI OMO purchases. Despite the net market borrowing of the centre remaining fairly stable over the last few years, the absorption of the net supply of SLR securities has remained challenging in the absence of RBI OMO’s. While the improvement in general government balances would be revenue driven and likely to be achieved only over time, in the current context of existing and potential near term continuing challenges with respect to broad-based revenue pick up, augmenting demand side remains the fairly obvious challenge as well as near term necessity with respect to government borrowings.
The backtracking on the Budget announcement of considering overseas sovereign bond issuances may have been driven by the reticence to subject the sovereign balance sheet to currency vulnerabilities and its associated impact on FX and domestic rates. However, it is interesting to observe that the current calendar year has witnessed overseas borrowings by Indian corporates of more than $22 bn. This issuance list includes PSU’s with covenants linked to the ownership, directly or indirectly. Given that external borrowings by the sovereign remains a much-debated issue within policy circles, with conservatism winning the argument for the time being, the alternate option would be to materially relax rules governing onshore rupee ownership of Indian bonds with the intent of being included in prominent indices. This may potentially open the route for additional external capital to enter the domestic sovereign markets.
Author is Head – Fixed Income, SBI Mutual Fund