What is RBI trying to achieve with GSAP, VRRR and all that

The RBI/MPC kept policy rates on hold on Wednesday as was widely expected. The “time based” guidance (accommodative into next financial year) was dropped, while the “state-based” guidance was reaffirmed (accommodative stance till prospects for a sustained recovery are well secured). Again this was the most likely anticipated outcome in terms of guidance, given that the RBI/MPC may not have wanted to tie themselves into a time commitment in what is an exceedingly complex and uncertain global economic framework.

Still as far as guidance goes, the utility of a state-based guidance from a market’s standpoint is limited at this juncture. This is because economic data will likely jump around substantially given both base effects as well as on the re-opening over the next few months, thereby making it that much harder to assess the threshold that qualifies as securing a durable recovery from a monetary policy standpoint. Nevertheless, the policy has enough and as is usual the real “action” is actually outside of the MPC review.

Normalization exactly as the doctor ordered
It is well-understood that the current level of overnight rates is too low and, thus, has limited shelf-life. The state-based guidance provides some continuation of it for now, but soon enough (likely later this year) the central bank will need to start adjusting the reverse repo rate higher. However, what is also true is that both the extraordinary steepness of the yield curve as well as the pricing embedded in the swap curve abundantly display that the market is quite prepared for this normalisation process ahead. Given this, a key consideration for the normalisation process is to ensure that while overnight and near-term rates are adjusted, their transmission to rates higher up the curve is much more muted. Put another way, the yield curve is expected to start losing some of its steepness as the overnight rate starts going up.

The new set of tools unveiled on Wednesday are exactly aimed at achieving the above. Thus, RBI has announced that it would start doing longer-term variable rate reverse repo (VRRR) auctions than just the 14-day ones that had been started from January. These will presumably ensure that as the market asks for higher rates to lock up liquidity for longer, the term structure on near-term rates will start to rise. Simply put, while overnight rate may keep on hovering around the reverse repo rate, rates on say one month to 6 months may start rising somewhat, reflecting the cut-offs on the longer term VRRR (it is to be noted that a lot here will depend on the tenor of VRRRs announced as well as their eventual success).

If that happens, then it will allow RBI to start normalizing the exceptionally low levels of near-end rates that exist today without courting the signalling complications embedded in actually hiking the reverse repo rate at this juncture. In order to doubly ensure that the intent of VRRRs is well understood, it has taken pains to state that these operations should not be read as liquidity tightening. In other words, there is no signaling effect here that needs transmission higher up the curve.

Then to doubly ensure that there’s little or no transmission up the curve, and to also continue to help markets in navigating the bond supply ahead, RBI has announced a new secondary market government bond acquisition program termed G-SAP 1.0 (aptly named given the ‘gasp’ of relief that many bond market participants may have inadvertently emitted on hearing the announcement!)

Under this, the central bank is upfront committing to a specific amount of open market purchases of government bonds (pegged at Rs 1 lakh crores for Q1 FY22). The first purchase under this for Rs 25,000 crore will be done on April 15. The program is over and above other tools already in use. The execution procedure here is still not fully known, and this is different from the existing OMOs done. However, nuances apart, the larger point here is that by providing upfront guidance on the extent of near-term bond supply absorption that the central bank will undertake, it is ensuring that the market doesn’t face undue volatility. In fact, and again to his credit, the Governor has explicitly laid out the objective of the program (“to ensure orderly evolution of the yield curve, governed by fundamentals as distinct from any specific level thereof”).

This is consistent with our own thought that RBI is not trying to control either direction of movement or trying to set a line in the sand with respect to yields. Rather, it is attempting to control the volatility as this evolution occurs. To that extent, Governor Das has brought to the rates market a philosophy that has been long stated with respect to the currency markets.

Prospects of ‘imported’ tightening
While the policy clearly starts out a well-thought-out plan for normalization as assessed above, the other question also is whether international developments can force the RBI’s hand. Remember here also that a currency depreciation, especially in short and rapid bursts, in an emerging market (EM) context may not necessarily equate a net financial conditions loosening as it does for developed markets. This is because export responsiveness in EMs to weaker currency may be limited given production/infrastructure constraints. Whereas the major benefit that accrues when global financial conditions ease is via the capital flow channel which in all probability will be in reversal during episodes of currency weakness (outflows may be causing the weakness).

Having established this, one can now turn to a somewhat speculative discussion on the prospects of imported tightening. It is well appreciated that most of the recent upsurge in the global reflation trade is led by the new $1.9 trillion US fiscal stimulus that has finally seen the light of day. This is to be followed by a new infrastructure stimulus as well. All told, the US administration has by now used circa 25% of GDP worth of a fiscal response; indeed much in excess of the actual economic loss imposed by the virus.

Basis this, one line of expectation that now runs is that the US economy will power ahead, inflation will rise, interest rates will have to reflect the fact (with or without the Fed), and capital will start getting pulled back from EMs. In such a scenario, EM central banks including our own RBI may have no alternative than to start course correcting monetary policy aggressively. Indeed, more that local growth inflation dynamics, this is possibly the number one question that should dominate discussions around policy at this juncture.

To clarify, the above paints one scenario only; and it is not a commentary on how things are likely to go. In any case, given the vast unknowns, the discussion is speculative in nature. A more constructive line of thought is to focus on the underlying dynamics of the problem, the anatomy of it as it were, and then try and glean some probable outcomes. In this context a relevant observation is that we may have already seen the peak intensity in US fiscal expansion. From here, most of the additional spending (like the infrastructure plan for example) may be significantly funded by tax increases as opposed to an outright major additional expansion.

The assessment now has to shift towards the efficacy of this spending in generating durable growth or, put another way, the growth multipliers embedded in this spending. As is well known, the multiplier effect of revenue spending is both weaker and less durable and insofar as that much of the US fiscal spending done already may be of this nature, it is unlikely that the effects on growth will last beyond a year or two.

Looked at it another way, US households have substantially higher savings courtesy the fiscal transfers from the government. The question really is what portion of this they think appropriate to spend which in turn will depend upon their confidence with respect to their more medium term economic prospects. Firms, in their turn, will only put up substantial higher capacity if they think most of the demand created from these fiscal transfers will likely prove durable. Else some of this demand may “leak out” offshore and get manifested in a wider US current account deficit for a while. Thus a lot of debate with respect to the likely course of US monetary policy and hence on the prospects of imported tightening for EMs like ourselves, will actually revolve around the growth multipliers of fiscal stimulus now that peak intensity on actual fiscal expansion is already passing us.

The Fed’s own view is that the bump up will likely be transitory and it doesn’t see a need to respond to this via policy tightening. It’s sympathy with respect to the fiscal stimulus really lies in the ability of this stimulus to get the economy back to full employment where the recovery starts trickling to the more vulnerable parts of the population. Additionally it believes that longer term factors (debt, demography and de-globalization presumably) may turn out to be more powerful in controlling medium term inflation spill overs. Truth be told we have sympathy for the argument and do believe that notwithstanding short term bursts, the longer term fallouts of this phase are unlikely to be inflationary (in an excess demand sense) given the substantial increase in debt load and associated efficiency destruction that is currently underway.

The way forward
RBI has well-equipped the market today for what may otherwise be an uncertain few months ahead in terms of global economic developments. As described above, we will likely see significant data spikes as both base effects as well as re-opening and fiscal stimulus led spending effects kick into gear. The question really is whether they will provide enough evidence to markets to continue the current pace of reflation repricing or, given the forward looking nature of markets, more sympathy will be found towards the idea that peak stimulus intensity is behind us and growth multipliers purchased may be weaker and shorter lasting.

Our current assessment is that the pace of reflation repricing should start settling down thereby providing room for RBI as well to pursue an orderly normalization process ahead. India’s lesser reliance on global debt flows lately as well as the slightly modified central bank approach now to focus also on reserve accumulation to buffer macro stability, further support the idea of an orderly normalization.

In the meanwhile, the central bank has delivered on most of what bond market participants may have reasonably asked for given the circumstances. The yield curve is very steep even at intermediate duration points (5– 6 years), thereby providing strong compensation for holding bonds as against cash. The important distinction to appreciate here is this: when yield curves are flat, as they used to be till a few years back, then investing even in medium duration bonds may make sense, only if there is an expectation of capital appreciation (that is falling yields). However, when the curve is as steep as it is today, the consideration isn’t capital gains, but rather volatility and/or the pace of rise in yields, which will dictate how much of the excess carry on offer will actually get realised by holding the bond.

This also means that the optimal ‘exploitation’ of steepness isn’t necessarily by owning longer duration points since the realization of carry there may be more compromised when yields move adversely. Rather one has to choose appropriate points on the curve where ‘carry-adjusted-for-duration’ makes the most sense. The current yield curve is quite steep till 5–7 years and then the additional duration risk taken may start overwhelming the additional carry on offer, in our view. Hence our preference in our active duration mandates remains currently best expressed as an overweight in the 5 – 6 year part of the government bond curve; with the usual caveats on flexibility in strategy retained with us. This also emphasizes the importance of some amount of “bar-belling” where the investor uses intermediate duration products alongside very near-term (almost overnight) exposures so that while overall portfolio maturity doesn’t go up, the investor is relatively protected when the commencement of the normalisation process starts to put upward pressure on money market and short-end rates.

(Suyash Choudhary is Head of Fixed Income at IDFC AMC. Views are his own)