Repo rate below 6% after 2010. What does this mean for debt mutual investors?

"Bond funds with longer maturity profile may benefit from the rate cuts though liquid fund returns will likely fall."

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By Arvind Chari

The Monetary Policy Committee (MPC) of the Reserve Bank of India delivered its third consecutive 25 bps rate cut but the first unanimous decision in this rate cutting cycle. It has of course also coincided with the change in the RBI Governor with Shaktikanta Das voting for the rate cut in all 3 meetings.

The MPC having voted 4-2 in the February and April policy meetings when they reduced the Repo rate from 6.5 per cent back to 6.0 per cent ; voted 6-0 in the June policy meeting to take the Repo Rate to 5.75 per cent .

This holds significance as the repo rate has breached below the 6 per cent rate for the first time since 2010. That tells you that India has struggled to get low interest rates over many years now.

In the 4 per cent CPI Inflation Target plus 1-2 per cent real rate framework, we do not expect the repo rate to go and sustain below the 6 per cent range.

So this rate move below the 6.0 per cent level and one that was secured with an unanimous vote is particularly noteworthy.

What is of even more significance is the change in stance to accommodative.

The RBIs response to the question on accommodative stance leaned more towards the direction of ‘with the move to accommodative stance, rate hikes are out of the table’.

The markets should of course read it as a clear indication that the RBI is deeply concerned about growth and is prepared to use interest rates and liquidity to boost demand.

We expect another 25 bps rate cut in August but will caution against too much exuberance on rate cuts post that.

That the Repo rate has been cut below 6 per cent and the stance has changed to accommodative has happened only twice in the last 20 years; Once post the Lehman crisis, 2008-2009 and the other post the dot com, global slowdown in 2002-2003 period. As we noted above, it is not a common occurrence in India. We should also note that growth prospects were way lower during those times to justify Repo rates well below 6 per cent.

In 2008-09, they were fighting a global financial crisis and responded to it by cutting rates sharply and adding in huge amounts of liquidity. We do now know in hindsight that delayed rate hikes by the RBI then did end up complicating the macro-economic and fiscal issues.

In 2002-03, India was running a current account deficit on the back of global slowdown; the then NDA government was successful in keeping inflation low despite drought and at the same time attract capital inflows. RBI responded to support growth as well as to dampen capital inflows and keep INR under check.

The MPC, this time, although worried on growth, has still retained the GDP forecast at around 7 per cent. At above the 7.5 per cent GDP growth (in the new series) is where the RBI believes is the potential level of output growth. So if they believe the 7 per cent GDP target for FY 20 to be true, there isn’t much panic and need to cut rates aggressively to push up growth to potential.

GDP growth has of course been on a downslide for a few quarters and we believe a major reason to be due to liquidity not being to the sufficient level in the economy. The Currency to GDP ratio has remained below its long term average since demonetization and we wonder whether India has indeed had trouble in adjusting to the lower cash in the system. We very commonly hear the Mumbai business trader lamenting ‘market mein paisa nahin hein’; the real estate market is also stuck in low sales resulting in cash being stuck in assets not liquidating. Are these due to lower overall liquidity in the economy?

The RBI has added considerable liquidity into the system especially in the last 6 months and we expect that currency which went out of the system pre elections should come back in the next two months. By August when RBI declares its dividend, system liquidity should be in a comfortable surplus aiding monetary transmission.

The RBI, in past, has preferred Open Market Operations (OMO) and recently introduced long term FX swaps to infuse durable liquidity in the banking system. Although they can continue to use these and long term repos for liquidity infusing, we believe cutting Cash Reserve Ratio (CRR) for banks can have a better impact in terms of transmission. Now with LCR (Liquidity Coverage Ratio) in place along with the SLR (Statutory Liquidity Ratio), the RBI should take a fresh look at the CRR requirements especially for its virtue of having a lasting effect on the system liquidity and banks’ financial position.

They have set up a working group to review the existing liquidity framework and they have also assured the market of timely response to the NBFC issue. We believe the credit crunch in the NBFC space is mainly due to Investors’ trust deficit over the financial position and asset quality of some non-bank lenders. Thus mere liquidity infusion may not be able to resolve the issue. The RBI did stay away from explicitly announcing any liquidity support for NBFCs which seems to have left the Equity Markets disappointed.

For the bond markets this was a good policy particularly with the change in stance to accommodative opening up space for further rally in the bond prices (fall in bond yields). Bond markets have already rallied a great deal in last one month with the 10 year government bond yield down from 7.4 per cent in April to near 6.9 per cent now. However, at current levels it still looks attractively valued as more rate cuts get priced in.

Bond funds with longer maturity profile may benefit from the rate cuts though liquid fund returns will likely fall with the cut in repo rates and the desire to keep surplus liquidity. Dynamic bond funds, which allow the fund manager flexibility to change the portfolio positioning depending on the emerging situation is a better alternative for the investors who wish to allocate to bond funds and can have a holding period of 2-3 years. But we would caution that the extent of fall in bond yields will remain limited unless the RBI gets more scope to cut rates below 5.5 per cent.

Investors with low risk appetite should thus stick to liquid funds to avoid any sharp volatility in their portfolio value. However, while choosing such funds also one should be aware of the credit risk and prefer funds which take low credit and liquidity risks.

Investors should also note that the credit crisis which began in the bond markets in September 2018 is not over yet and investors should remain cautious and should choose debt and liquid funds which priorities safety and liquidity over returns in the current times.

(The author is the head of fixed income and alternatives at Quantum Advisors.)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of
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