RBI’s Operation Twist? Not quite
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The RBI last night announced a series of measures to try and mitigate the collateral impact arising from the interest rate defense over the last month. Specifically, rising-long term yields have created significant disquiet in markets as they threaten to further pull-down growth, increase the government’s borrowing costs and further imperil the fisc, and increase mark-to-market losses on banks’ portfolios. To mitigate these impacts, the RBI signaled they will resume OMO purchases to contain long term yields. In addition, the central bank announced a series of measures to help banks’reduce and spread out their mark-to-market losses from the hardening of yields. All this was understandable and not inconsistent with the interest rate defense. But what surprised markets is that the central bank indicated that the “the immediate objective of raising the short-term interest rates has substantially been achieved.” Markets took this to mean that further increases in the penal MSF rate are effectively off the table. The central bank also announced it would potentially scale down the issuance of short-dated instruments to soak out liquidity, implying that short rates remain near the MSF rate but are not substantially higher. Some have characterized the RBI’s move as Operation Twist, keep short rates high and try to push down long term yields. But this is no Operation Twist. Instead, the entire yield curve has gapped down 50-70 bps, with short rates falling as much and, in some cases, even more, reflecting a significantly reduced probability of more monetary tightening. Prima facie, one would have thought this latest round of measures would have excited the equity market which, in turn, would prop up the currency. Instead, equity markets declined by a whopping 2% today. That contributed to USD/INR down weakening another 1.4% which touched another all-time low intra-day. Why do expectations of the Rupee matter so much for the BoP? Because, contrary to public perception, this is not a current account problem anymore. The estimated monthly CAD plunged to just over $2 bn in June and July vis-à-vis $10 bn the previous two months. The combination of gold imports plunging and exports picking up have all but squeezed the CAD the last two months. But India was unable to even finance a CAD of $2.5 billion per month over the last two months. Instead, reserves had to finance the entire CAD in June and July with estimated net capital inflows close to 0. So this is not a CAD problem any more. It’s squarely a capital inflow problem. Why? Isn’t the Rupee cheap at current levels? The Rupee is only cheap if you believe it is not going to become cheaper (similar to what deflation does to postponing consumption). As long as the rupee continues to weaken, it will be hard to attract even capital flows that ordinarily would have entered. As such, ensuring a semblance of Rupee stability for a few weeks must be policymakers only priority for the time being. And that is why it’s critical that the interest rate defense not be diluted or undermined in the bid to lower long-term yields. It’s all very well to mitigate the collateral damage. But given the challenging global macro and the Rupee 4% fall over the last week, let’s not throw the baby out with the bathwater. One of the inevitable consequences of the interest rate defense employed by policymakers over the last month is that interest rates would rise, to varying degrees, across the entire term structure. Expectedly, the yield curve moved up and inverted further. By Monday evening, for instance, the overnight inter-bank call rate (after lots of starts and stops) was at the penal Marginal Standing Facility (MSF) rate of 10.25% (the desired intent of the tightening), short term interest rates (e.g. 3 month T Bill) had risen all the way to 11.6%, reflecting expectations of potentially more tightening if the Rupee suffered more. These factors, in conjunction with the fact that the RBI’s bond purchases had been suspended to maintain the liquidity squeeze (Recall: OMOs were instrumental in capping longer-ended bond yields over the last year) meant that 10Y benchmark bond yield had risen 170 bps to 9.2%, effective resulting in a kinked, but more inverted, yield curve. The rise in long-rates, in particular, has understandably created a lot of disquiet among some sections of the market. For one, if the rise in bond yields were to sustain, it would likely further dampen growth and hurt bank asset quality. Second, hardening of yields was expected to result in sharp mark-to-market losses on banks’ investment portfolios at the end of this quarter (September 30th). Third, the rise in yields would push up the government’s borrowing costs and make the precarious fiscal situation worse. Operation Twist? Given these rising concerns, the RBI announced several measures to mitigate the collateral damage from its interest rate defense. A key objective of these measures was to cap long-term bond yields ostensibly to mitigate the impact on growth. To achieve this, it indicated it would resume open market purchase operations (OMOs) of long dated G-Secs to the tune of Rs. 80 billion on August 23, 2013, and“thereafter calibrate them both in terms of quantum and frequency, as may be warranted by the evolving market conditions”. This clearly suggests the RBI is likely to revive its OMO program to cap long-term bond yields. Expectedly, bonds have rallied sharply with yields falling 50 bps since the announcement. Lower yields also help government borrowing costs and reduce bank’s mark-to-market losses. This much was understandable – given the pressures that were building – and are being characterized as the RBI’s version of “operation twist” – the RBI squeezing liquidity through issuing shorter-dated instruments at the short end while simultaneously buying longer-dated 10Y bonds to push those yields down. Not Quite This would have been the case had the central bank ensured that short rates stay around the pre-announcement levels. Instead, the RBI signaled that“the immediate objective of raising the short-term interest rates has substantially been achieved” and that “going forward, the Reserve Bank will calibrate the issue of cash management bills (CMBs), including scaling it down as may be necessary, to keep the money market rates around MSF rate until the volatility of rupee eases”. Markets took this to mean that the likelihood of further increases in the MSF has all but vanished and that supply of shorter dated instruments to soak out liquidity would be less than previously expected – such that short rate stay close to the MSF rate of 10.25% but are not substantially higher. Unsurprisingly, therefore, short rates have fallen as much – in some cases even more – than long yields. For example the 3-month T-Bill yields has fallen 62 bps and the 1-yr T-Bill has fallen 72 bps – more than the moderation of longer-dated yields. This is no operation twist. There has been a gapping down of the entire yield curve with, if anything, short rates falling more than their longer counterparts. Markets have been surprised by this. One would have thought the measures would focus on bringing down long yields (through OMO announcements, for example) without measures to commensurately reduce short rates, such that the dual purpose of reducing collateral damage while maintaining policy continuity and resolve would be addressed (but more about potential implications below).   Regulatory forbearance for banks In addition, the RBI undertook regulatory forbearance vis-à-vis banks so as to help them reduce their mark-to-market losses. Specifically, it allowed banks to:
Why Rupee expectations matter: it’s a not a CAD problem any more Mounting an interest rate defense was never going to be costless. There was always going to be collateral damage but policymakers, correctly in our view, perceived that further depreciation of the currency could, by itself, be stagflationary and very disruptive in the short run. And, therefore, it is also very understandable that policymakers moved to mitigate some of this collateral damage by capping longer term yields. Furthermore, with some of these costs mitigated, market pressure to roll-back these measures is likely to fall, and the interest rate defense can be expected to sustain for longer. But in walking this tightrope, it is important that policymakers do not inadvertently dilute or undermine the original intent of the interest rate defense. Because, whatever else you think about its efficacy, if markets believe that policymakers are walking it back, the pressure on the Rupee could rise even further. Already, the market perception is that the likelihood of future tightening is all but off the table. Prima facie, one would have thought this latest round of measures is growth-positive and would have excited the equity market which, in turn, would prop up the currency. Instead, equity markets appear confused and have declined by a whopping 2%. This has also helped pull the USD/INR down another 1.4% which touched another all-time low of 64.63. Why do expectations of the Rupee matter so much for the BoP? Because, contrary to public perception, this is not a current account problem anymore. The estimated CAD plunged to just over $2bn in June and July vis-à-vis an average of $10 billion over the previous two months. The combination of gold imports plunging and exports picking up has all but squeezed the CAD. But India was unable to even finance a CAD of $2.3 billion per month over the last two months. Instead, reserves had to finance the CAD in both months, with estimated capital flows being close to 0. So this is not a CAD problem any more. It’s squarely a capital inflow problem. The portfolio outflow didn’t help, but other capital inflows have not offset this. Why? Isn’t the Rupee cheap at current levels? The Rupee is only cheap if you believe it is not going to become cheaper (similar to what deflation does to postponing consumption). As long as the rupee continues to weaken, it will be hard to attract even capital flows that ordinarily would have entered. As such, ensuring a semblance of Rupee stability for a few weeks must be policymakers only priority for the time being. And that is why it’s critical that, along with appropriate FX intervention, the interest rate defense not be diluted or undermined in the bid to lower long-term yields. It’s all very well to mitigate the collateral damage. But given the challenging global macro and the Rupee’s 4% fall over the last week, let’s not throw the baby out with the bathwater.   |
J.P. Morgan Securities LLC |
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