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RBI Policy: Good that the walk is more hawkish than the talk

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Beneath the lingo and outside of the MPC’s remit, RBI has changed the amount and way it reduces the surplus liquidity in the market and that’s the welcome hawkish element.

RBI Policy: Good that the walk is more hawkish than the talk
At first glance, the Monetary Policy Committee (MPC) and the Reserve Bank of India (RBI) have retained monetary policy exactly as in August. Not a coma has changed in the stance: "to continue with the accommodative stance as long as necessary to revive and sustain growth on a durable basis". But beneath the lingo and outside of the MPC’s remit, RBI has changed the amount and way it reduces the surplus liquidity in the market and that’s the welcome hawkish element.
To go back to the MPC policy, every decision is exactly as the CNBC-TV18 poll had indicated: An overwhelming majority expecting no change in the reverse repo or the repo rates and none expecting the policy stance to change from accommodative. The surprise comes in the steps to cut liquidity. At the moment, on a daily basis, banks hand in about Rs 8.5 lakh crore of funds to RBI for overnight to 14-day duration, because there aren’t enough takers for loans. RBI too has been increasing the liquidity by buying government bonds and dollars from the market, both to keep the rupee cheap and to keep yields low. Our poll respondents and our citizens MPC were unanimous that so much liquidity sloshing around is uncalled for, and can be potentially mischievous.
Expectedly RBI tightened. It said it will stop the pre-announced purchase of government bonds (called GSAP or the Government Securities Acquisition Plan) but stand ready to buy via OMOs ( Open Market Purchases ) or Operation Twist ( buying long tenor, selling short) as warranted. This was the surprise: the market wanted the comfort that RBI would buy a minimum of at least Rs 50,000 crore of government bonds under the GSAP. The nil number on GSAP is like swimming without a float, for bond dealers.
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The second surprise of tightening was the quantum of variable rate reverse repo ( a 14-day instrument that RBI uses to suck out liquidity). RBI said it would start with a Rs 4 trillion VRRR on October 23 and systematically increase the quantum to Rs 6 trillion by early December, by when the surplus liquidity should drop to a little over Rs 2 trillion. The market didn’t expect such a rapid suck out. In fact, RBI went further to add that it may consider doing 28-day VRRRs if needed.
The October 8 policy can thus be called a rate hike by stealth. Here's why: Even as the press conference of the governor was underway, the previous 14-day VRRR auction results came in at a cut-off of 3.99 percent. This is the second consecutive auction where the RBI took 14-day money from the market for 3.99 percent. This. when 1 month-3 month CPs are trading between 3.6-3.7 percent and three month to one-year Treasury Bills are trading at 3.5-3.9 percent. Now, why would banks buy one-year t-bills at 3.9 percent, or one-month CPs at 3.6 percent when they can get 3.99 percent for 14 days from the best borrower.
The implication is clear. Banks will sell of t-bills and CPs and their yields will rise but maybe not to 3.99 percent because mutual funds who don’t have access to the reverse repo window will be willing buyers at higher yields. Likewise, as banks shift money away from t-bills and CPs those yields will rise even as the 14-day reverse repo yields may fall. But importantly, t-bill yields from one month to one year are set to rise and hence a host of corporate loans benchmarked to t-bills will also rise.
Moral of the story: RBI has effected a rise in short term yields without a reverse repo hike. Cynics may say the RBI fell short of being candid. But the governor put it well: "We don't want to rock the boat when the shore is near as there is a journey beyond the shores," he said, obliquely indicating that the RBI is coming to the end its super accommodative policy. It is possible that by December most short tenor yields may be closer to the repo rate, the borrowing programme would be mostly over and the RBI would probably have a sub-4 percent CPI behind it. From the position of strength, it may be better placed to hike the reverse repo.
It is fair to complain that there is a disconnect between the fairly rosy picture of recovery the governor and the government paint and retaining emergency measures like a 65 bps gap between repo and reverse repo which came at the height of the lockdown and the pandemic. Witness how the governor describes growth: Recovery in aggregate demand gathered pace in August-September. This is reflected in high-frequency indicators – railway freight traffic; port cargo; cement production; electricity demand; e-way bills; GST and toll collections... Rural demand is expected to get impetus from the continued resilience of the agricultural sector and record production of Kharif foodgrains in 2021-22 as per the first advance estimates... Improvement in government capex, together with congenial financial conditions, could bring about an upturn in the much-awaited virtuous investment cycle. Pick up in import of capital goods and cement production point towards some revival in investment activity. According to our survey results, capacity utilisation (CU) in the manufacturing sector, which declined sharply in Q1:2021-22 under the second wave, is assessed to have recovered in Q2 and further improvement is expected in the ensuing quarters.
If the economic recovery is underway, is it playing with fire to keep rates so low and liquidity so plentiful? Can there be accidents like mispricing of assets and fuelling of equity markets with this ultra-cheap money? These are fair worries, but these are also entangled with global issues. To be fair RBI has undertaken the journey towards normalization, stealthily, if not overtly. Two cheers for that.
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