RBI cut the Repo Rate by 25bps in its first Bi-Monthly Policy Statement today on the 5th of April 2016. RBI has also indirectly cut policy rates by 50bps through two measures. RBI policy is extremely bullish for bond markets and this bullishness will filter into a strong INR as well as into a strong equity market sentiment.
RBI has maintained its accommodative policy stance forecasting economic growth at 7.6% and CPI inflation at around 5% for this year. The Central Bank has recognized the government’s commitment to lowering fiscal deficit to 3.5% of GDP for this fiscal year and believes that inflation will be stable despite push from Rs 1100 billion inflow into consumer’s hands through the 7th Pay Commission recommendation implementation. Global economic growth is still a challenge, commodity prices are still soft despite a sharp rise from lows over the last one month and headwinds are persistent in the form of China growth slowdown, Japan economic weakness and Eurozone economic issues including high unemployment, low inflation and migrant crisis.
The yield on the benchmark ten year bond, the 7.59% 2026 bond, fell 8bps post policy as markets reacted positively to the 75bps rate cut (direct plus indirect). Sensex and Nifty however fell as equity markets were expecting a direct 50bps rate cut while the INR fell from highs but is still higher from previous day’s close.
How 50bps Indirect Rate Cut?
RBI has changed its policy on liquidity from keeping the system in deficit to keeping the system in neutral. System liquidity has deteriorated significantly over the last one year due to government keeping surplus balance (around Rs 1500 billion end March 2016) and money flowing out from the banking system in the form of currency in circulation (over Rs 2000 billion). RBI had to lend a record Rs 3300 billion end March on the back of this huge liquidity deficit.
Banks have seen the slowest deposit growth in fiscal 2015-16 since 1962-63 and Incremental Credit Deposit Ratio (ICDR) at 87% as of 18th March 2016 has resulted in a fund crunch for the system. Banks have considerably slowed down growth in investments from 13% levels to around 6% levels over the last one year and this has implications for government borrowing as well. Banks SLR has been cut by 25bps as of April 2016 and will be cut by another 75bps over the next three quarters and that will further reduce bank’s demand for government bonds.
RBI in order to address the structural liquidity deficit and to address lack of bank demand for government bonds has changed its policy from keeping liquidity in deficit by around 1% of NDTL to keeping the system in neutral.
Given NDTL of around Rs 93 trillion, this would mean that RBI would be infusing primary liquidity of close to Rs 1000 billion into the system. This could be from buying USD or from buying government bonds. Given that capital flows have been muted with FII’s flows being negative in the last fiscal year, RBI will be more inclined to buy government bonds.
RBI lowered the Repo to Reverse Repo and MSF corridor from 100bps to 50bps. RBI envisages that with its liquidity operations, it will become more of a borrower from banks than a lender to banks. Operational rate will move towards the Reverse Repo Rate of 6% rather than the Repo Rate of 6.5%. This is the indirect cut of 50bps in rates.
RBI has also allayed fears of outflow of over USD 30 billion from FCNR B deposits as it has fully covered the outflows through its forward market operations.