The changing face of monetary intervention

The pandemic has silently set in motion a change in the way we approach monetary action. It appears that the straight jacketed concept of targeting CPI inflation is passe and no longer should be treated as being the prime driver of monetary policy action.

A more flexible stance has been assumed by the MPC which is reminiscent of the earlier approach that the RBI took when interest rate decisions were based on a hybrid objective of striking a balance between growth and inflation. This added a new dimension for the market as the trend in inflation no longer mattered and, MPC decisions were based not on current but future growth perspectives.

While the inflation constraint has prevented the MPC from lowering the repo rate, the message sent out is one of accommodation, where the RBI will ensure ample liquidity in the system.

More importantly interest rates will not be hiked. Provision of liquidity ensures that finally interest rates get impacted and the objective of the repo rate is achieved albeit through a different route. Once G-Sec rates get affected there is automatic transmission to the corporate bond market as well as bank rates.

The puzzle today is that there is surplus liquidity in the system which has been created by a combination of two sets of factors.

The first is that growth in credit has lagged that of deposits. Second, the RBI has been relentlessly inducing liquidity through the LTRO and TLTRO operations besides conventional OMOs during the pandemic to ensure that banks had enough to lend.

As the appetite for credit is low, such infusions have led to build up of excess liquidity in the system. Hence there have been large flows to the reverse repo window and at an average inflow of ₹4 lakh crore on a daily basis; the interest cost for the RBI would be ₹13,500 crore. Yet, the RBI has been conducting OMOs. So, what exactly is the idea?

The OMO purchases have been scheduled such that the central bank buys targeted securities thus pushing up their prices and lowering the yields. This has become more distinct after the Budget when the bond yields spiked because the market believed that the large quantum of government borrowing would drive yields up next year.

To assuage sentiment the RBI has been conducting OMOs in the face of surplus liquidity. In FY19 the RBI conducted a record ₹3 lakh crore of OMOs due to the shortage of liquidity in the system. But this time the OMOs have been conducted despite a surplus, but the objective is different, which is to lower the bond yields. And what is being apparently targeted is the 10-year bond yield at less than 6 per cent.

The other route being used is the rather colourfully named — Operation Twist, where the central bank buys and sells securities of the same magnitude so that overall liquidity remains unaffected.

This year around ₹1.4 lakh crore of such operations were conducted till February 7. Here, the securities are strategically chosen to influence the yields of some of them so that the linkage effects work out and spread to the market. This unique approach was earlier conducted to create liquidity in paper that required a boost or pull out those which were not being traded to clean up the bouquet. Now the goal is to lower rates.

Market reaction

How has the market reacted? As can be seen in the last couple of auctions there was devolvement on the PDs which in turn has made the RBI more aggressive in its auctions/OMOs, which have been laced with messages on being accommodative to ensure that the market is assured of future action too.

What has this meant? Relentless driving down of bond yields has severed the link between demand-supply of government bonds, skewing the market. Keeping the yields low will also have an impact on the interest rates that are linked with them starting from treasury bills, commercial paper, corporate bond yields and small savings rates.

In the second round, banks will have to reconsider their interest rates on both the deposits and lending sides even though the repo rate remains unchanged.

This can be the new approach of monetary policy to tackle a situation where the market is sceptical of the government’s borrowing programme. By using various instruments of monetary control, the RBI has in fact managed to take interest rates in the desired direction even though they may not be in consonance with the principles of economics.

A question that can be asked is whether the price of capital is being priced in the right manner? While the target is government bonds which are risk-free, the same becomes an anchor for other interest rates and hence there could be some mis-pricing.

There can be no objection to keeping the 10-year paper at sub 6 per cent, as it is the government which benefits big time in terms of the borrowing programme. With ₹12.8 lakh crore of gross borrowing, keeping the rate at lower levels helps to lower the interest cost for the government and a 50 bps across the board reduction leads to savings of around ₹6,400 crore on an annual basis.

The problem can be on other instruments where say a AAA rated bond has a yield of 60-80 bps higher than the GSec. The same holds for lower rated bonds which get priced in a similar fashion. As GSecs adjust the same is witnessed with the T-Bills which in turn become benchmarks for CPs based on their ratings.

Hence, the 10-year GSec becomes a kind of fulcrum for all other rates. While pricing of government paper is more notional, the same for commercial borrowing reduces the credit risk cost for borrowers which can be a concern.

But this appears to be the new route to be persevered with by the RBI to regulate interest rates, which the market has to accept.

The writer is Chief Economist, CARE Ratings. Views expressed are personal