How surplus liquidity, RBI’s actions have led to short-term rates falling below the repo rate

Substantial liquidity infusion via open market operations (OMO) and term repos, various policy actions taken by the RBI to ease liquidity conditions for NBFCs/HFCs, long-term repo operations, reduction in repo and reverse repo rate — have all led to a steep fall in short-term interest rates over the past few months. In fact, most of the rates are below the prevailing repo rate of 4 per cent; even close to or below the reverse repo rate of3.35 per cent in some cases.

According to the RBI’s July report, the weighted average call money rate has fallen 37 basis points below repo rate during April-June 2020 (from 17 bps below repo rate during January-March 2020). Importantly yields on commercial papers (CPs) issued by NBFCs/HFCs that had shot up post the IL&FS fiasco in late 2018, have also fallen sharply in the past few months. The yields on 3-month CPs for All India Financial Institutions (AIFIs) and HFCs, have dropped below the policy repo rate in June.

Surplus liquidity with banks over the past few months has reduced their reliance on certificate of deposits — an important source of short-term financing. But it has also led to yield on three- and six-month CDs falling below repo rate; yield on 3-month CDs have fallen below reverse repo rate in the past few days.

Lower borrowing costs

The RBI’s Targeted Long Term Repo Operations (TLTROs), wherein banks have to deploy the three-year funds under the facility in investment grade (BBB rated and above) corporate bonds, commercial paper, and non-convertible debentures, have helped in reducing borrowing costs for AAA- and AA-rated corporates. According to the RBI data, the yield on these corporate bonds are now the lowest in a decade. While yield on AAA-rated 3-year corporate bonds have fallen by about 100 bps in 2020, for AA-rated bonds the yields have declined by about 80 bps.

The easing of risk aversion through TLTRO is reflective in the narrowing of spreads between corporate bonds and G-Secs since late March. The fall in the spread of three-year AAA-rated NBFCs has been the maximum (from 320 bps in last week of March to 150 bps in June). For AA-rated NBFCs too spreads have fallen to 236 bps in June from a steep 392 bps in March. However, the spreads are still high when compared to last year (at 190 bps in April 2019). This indicates that risk aversion towards the NBFC segment persist despite the various steps taken by the RBI over the past year.

Weak transmission

One of the key factors for weak transmission in the past, in particular over the past year, has been the wide spread between 10-year government bonds and shorter tenure bonds. In a bid to ease interest rate on long-term government bonds, the RBI has conducted simultaneous sale and purchase of government bonds (operation twist), using proceeds from the sale of short-term securities to buy long-term government debt papers.

While this has helped narrow the spread, it still remains wide.

The yield on 10-year G-Sec that hardened towards the end of 2019, owing to worries over fiscal deficit, has fallen notably since January this year (about 130 bps), on the back of RBI’s continual liquidity infusion and special OMOs in April. However, the yield on longer tenure government bonds has not fallen as much as the yield on shorter-term G-Secs. The additional central government borrowing owing to the Covid pandemic, has led to the steepening of the yield curve — spread between two-year and 10-year G-Secs is a wide 158 basis points (as of June 25).

While yield on two-year G-Sec has fallen by 158 bps since January, yield on 10-year G-Sec has declined by a lower 86 bps.

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