Is RBI’s repo rate losing its relevance?

In usual times, RBI sets the tone for interest rates through its benchmark repo and reverse repo rates. Market then takes the cues from these rates to decide its course on the yield curve. That is a typical text-book style functioning of bond markets. But there are times when market takes the mantle from RBI to set the direction for the interest rates. Currently we seem to be in one such times with RBI falling well behind the curve.

Since the time RBI reduced the repo rate by over 120bps during the period of Feb-May 2020, repo rate has stayed put at 4%. Same is the case with reverse repo with its rate ruling at 3.35%. But, of late, bond markets have refused to buy-into this stability. Looking at the ten year Gsec yield, it hardly paints a stable picture that RBI is projecting through its repo rates. Since last October, it has sharply moved up by over 100bps reflecting market’s staunch refusal to fall in line with the RBI’s accommodative stance. In fact, the yield went all the way up to near 7% immediately after the presentation of budget, before cooling off to the current level of 6.75%+ (as on 24th Feb) level on a surprising (and adventurous to many) dovish stance of RBI in its latest policy announcement post the budget.

There is a justifiable reason why markets are refusing to toe the RBI line. Besides inflation scare, latest budget has also added to the market’s ire on the borrowings. Here is how it stacks up.

From the equity market’s point of view, this budget has been a success, esp. if one goes by the stock market’s response in the days following the budget. It has lapped it up with all cheers, because of the budget’s focus on capex and growth. There is nothing in the budget fine print to upset the equity markets. Given the capex and growth push, the economy facing stocks in the broader space will do very well in the coming months. In effect, the budget is going to push further the economic momentum which the country is already witnessing on account of turn in capex, property, credit and export cycles. But if one looks at from the bond market’s point of view, the picture is not all that rosy.

If at all if there is any risk from this budget, it is likely to come from the bond market. During the budget presentation, there is one number which the bond markets weigh anxiously is the Govt’s borrowing level. This time, the large borrowing number in the budget (Rs 11.51tn net borrowings) for this year came as an unpleasant surprise to the bond markets. Bond markets were not prepared for this huge increase (from Rs 9.67tn last year). Also, the bond markets were expecting some kind of tax benefits to FPIs so as to expedite the inclusion in global indices. There was no such tax concession announced in the budget. Now that there is going to be delay in bond inclusion, market is expecting this large borrowing to put pressure on 10 year Gsec. On that expectation, the yield spiked by over 30 bps (in the days following the budget), only to cool off to a much lower level post the RBI’s dovish policy announcement.

Will this cool-off be temporary? Should one be alarmed by this large borrowings? One should certainly be worried if the packed-up borrowing calendar pushes up the ten year Gsec yield in a dis-orderly fashion. But, given the ultra-conservative nominal growth projections in the budget, this risk is unlikely to play out. In our view, Govt. will have a lot of headroom to manage the fiscal space, because of the extra-ordinary cushion in the budget numbers. Look at the nominal growth as per Budget. It has assumed about 11.5%. But this is an extremely conservative number. If one takes the economic survey as the cue, the real GDP growth as per the survey is likely to be 8.5% for FY23. If one adds the most likely inflation number, one will get a much higher number for nominal GDP growth. As a result, the Govt. in all likelihood, will have a lot more flexibility to alter the borrowing plans as the year unfolds, if the bond yields moves in a dis-orderly fashion. Even in the current year (FY22), Govt. had originally estimated to borrow around 9.67tn, against which the revised estimates are likely to be only 8.75tn. While the Govt. will have a lot of leeway in the managing the borrowing calendar as cited above, new geo-political risks such as Russia-Ukraine situation could play a spoil sport. If this conflict plays out for an extended time, it will have the potential to upset the inflation/interest rate dynamics for India from pressure points that are fed through elevated oil and commodity prices.

In summary, in the context of these evolving risks, it is rather surprising that RBI chose to keep the accommodative stance with super dovish tone in its latest policy pronouncements. Only time will tell whether RBI has been wise in its move or audaciously adventurous in its accommodative stance. Interesting times to watch out for!

This article of mine was published in the online edition of Economic Times (26/02/2022). Glad to share the link: