Expect RBI to hike banks’ HTM limit by 4% of book ($84 bn), atop 2.5% in FY21, till FY26 (from FY23 now). This should incentivise banks to invest their money-market surplus (~$80 bn) in G-secs without fear of MTM hits when RBI likely hikes in FY23
The Reserve Bank of India’s (RBI) monetary policy committee is expected to extend its dovish pause today (Friday), in a bid to cap rising yields in the wake of a higher-than-expected fiscal deficit target by the government. Finance minister Nirmala Sitharaman’s decision to switch to a counter-cyclical fiscal policy to support recovery must be welcomed. At the same time, its success hinges on RBI’s ability to fund the higher fiscal deficit at a soft risk-free rate that allows further lending rate cuts.
BofA Global Research hence expects RBI Governor Das to re-commit that yields are now a ‘public good’ to comfort the G-sec market. We see RBI following a three-pronged strategy of hiking banks’ held to maturity (HTM) limits, stepping up open market operations (OMO) combined with long-term repo operations and finally, also buying FX in the forward market in addition. There is a slim chance of a 25bps cut in the repo rate tomorrow to reduce lending rates on SME/retail/mortgage loans linked to it, ahead of the slack season.
The RBI MPC is expected to be on long hold in FY22 and hike rates by 100bps in FY23. First, inflation should ease to 4.4% in FY22, within its 2-6% mandate, from 6.2% in FY21 on base effects (We track January inflation at 4.9%). Second, the higher fiscal stimulus announced in the Union Budget reduces the burden on monetary policy to revive growth. Finally, the RBI MPC will likely want to preserve some rate cuts for the future as delays in the Covid-19 vaccine mass roll out (to, say, the December quarter) pose 300bps risk to our 9% FY22 growth forecast.
We place the Center’s fiscal deficit at 7.2% of GDP (inclusive of direct FCI funding), assuming some slippage in the high PSU disinvestment target.
This translates into Rs 16,949 billion of net borrowing and excess G-sec supply of Rs 7,996 billion. In such a scenario, how can RBI fund this higher-than-expected fiscal deficit without fanning yields?
The options could be: We expect RBI to hike banks’ HTM limit by 4% of book (Rs 6,136 billion/$84 billion), atop 2.5% in FY21, till FY26 (from FY23 now). This should incentivise banks to invest their money market surplus, of almost $80 billion, in G-secs without fear of MTM hits at a time we expect the RBI MPC to hike in FY23 and 10y UST yield to reach 1.75% (BofAe) by December (Note, a 100bps hike in yields leads to 7.2% MTM hit.)
Second, it constrains RBI OMO when M3 growth, at 12.5%, is in excess supply, given an average 2% FY20-22 growth. It must be noted that RBI is already trying to contain money supply expansion by reducing OMO (that expands RBI balance sheet further). It is trying to channel the money market liquidity to G-sec auctions by hiking banks’ HTM limit and Operation Twist of buying long-dated securities and selling short-dated paper.
Finally, a softer risk-free should boost loan growth to 12.5% in FY22 as real lending rates are finally coming off on RBI easing.
RBI will likely resort to higher OMO combined with 2-3 year long-term reverse repos if banks hesitate to lock further funds in the HTM bucket given excess SLR of 10+% of book. In this case, it will directly bear the MTM risk. As banks raise deposits at about 5%, the reverse repo rate will likely have to be slightly higher. This can be partly reduced by CRR exemption on deposits mirroring long-term reverse repos.
A final way is for RBI to buy FX forward to deflect the immediate liquidity impact as it has done in the past. Such operations could be on-market or off-market. This will allow RBI to consolidate FX reserves as well as step-up OMO to support G-secs. Our BoP estimates place RBI FX intervention at $45 billion at a current account deficit of 0.5% of GDP in FY22.
How can Delhi help?
The proposed NaBFID finance institution could raise infra bonds (of, say, Rs 1,000 billion) to fund part of the budgeted investment in a fiscal- and liquidity- neutral manner. When a bank bids in a G-sec auction, it has to carve the investment out of its loan/investment book. As the money flows to the government account with RBI, money market liquidity shrinks. This is called crowding out in the argot.
If individuals break down their fixed deposit to buy a G-sec in a primary auction, money flows from his/her deposit account to the government account with RBI. This obviously impacts the bank as well as money market liquidity. If individuals buy a quasi Gsec/PSU bond, that is part of EBR, funds flow from, say, its fixed deposit to PSU’s current account. This does not impact either banks’ deposits, asset book or money market liquidity.
Hence, there is no crowding out. In short, G-secs are typically funded by bank liquidity, whereas quasis/PSU bonds are financed by leverage on bank deposits.