Prices pain less, RBI will bring the scalpel out

The Reserve Bank of India (RBI) will cut policy rates — the cash reserve ratio (CRR) and the repo — on January 24. The markets are effectively poised for rate cuts though the public posturing offers a contrarian view, that is, no rate cuts or at best, a CRR tweak. Expectations of rate cuts are so high that 10-year government bond yields are trading at 7-month lows. The benchmark 10-year paper — the 8.79% 2021 bond — too is hovering at 8.18%, down 70 basis points (bps) from the highs a couple of months ago.

A couple of likely scenarios merit attention. A 25-bps cut in CRR and the repo will lead to bond yields tumbling around 15-20 bps in the near term, but bond supply and liquidity would remain a big worry, which will push the yields higher. A 50-bps cut in CRR and the repo will trigger a 30-35 bps rally and yields will stay muted on expectations of a softer policy down the line. A 25-bps CRR cut will hold yields at current levels while absence of any action will translate into a 15-20 bps spurt in borrowing costs.  

The central bank is moving into its monetary policy review against the backdrop of lower inflation expectations, slowing credit growth and a downward revision in GDP forecasts. Inflation, as measured by the wholesale price index (WPI), came in at 7.47% for December 2011 against 9.11% in the previous month. The fall was led by primary article inflation, which came off from the level of 6.9% in November to 0.51% for the week ended December 30. Non-food manufacturing or the ‘core index’ also witnessed a similar trend, which declined to 7.7% in December 2011 from 7.9% in November. In fact, the stickiness in the core index has prompted analysts to call for no rate cuts, but as growth slows and economic uncertainties deepen, repo rate at over core inflation is not something that is considered as the best policy to flaunt. The repo, at 8.5%, is above core inflation, which will nudge the RBI to bring it down.

Credit growth, a barometer of consumption and investment demand in the economy, has slipped to below 16% mark on a year on year basis as of December 2011, which is a far cry from the 22% level at the beginning of this fiscal. The fall in credit growth is a positive sign for the RBI in its effort to tone down aggregate demand in the economy to douse rising inflationary expectations.

There is more to follow. The growth forecasts are getting revised downwards with the government now talking about a below 7% figure for 2011-12, from an earlier forecast of 7.5%. The slowing economy only attests to the RBI’s efforts to fight prices.

System liquidity as measured by the bids for repo in the liquidity adjustment facility (LAF) auction of the RBI tightened by Rs24,000 crore last week. Bids for repo at 8.5% in the LAF averaged Rs152,000 crore on a daily basis last week against an average of Rs1,28,000 crore seen in the week before. Liquidity conditions are showing no signs of easing despite the RBI buying almost Rs72,000 crore of bonds over the last 45 days and the government taking to borrowing from the Ways and Means Advances (WMA) window of the RBI. The government has drawn down close to Rs15,000 crore from the RBI as of the week ended January 12, 2012. Cash crunch restrains banks from lending, thus leading to a fall in credit growth.

Tight liquidity has also impacted the yields at the short end of the credit curve. One-year bank CD (certificate of deposit) rates have moved up 10 bps and are trading at a 6-month high of 9.90%. Credit spreads moved up on liquidity worries, with five and ten year AAA credit spreads going up by 4 bps each week on week to close at 4-month highs of 100 bps and 93 bps, respectively. The spreads will tick up on rate cuts as the liquidity conditions keep corporate bond yields in check. Status quo on policy rates will bring down credit spreads, as corporate bond yields remain sticky at higher levels.

The swap curve moved higher on account of liquidity staying tight. One and 5-year Overnight Index Swap (OIS) yields went up 16 bps week on week to close at 8.02% and 7.28%, respectively. Easing of rates will bring down the curve while no rate cuts will lead to a marginal rise.

Government bond auctions
The government auctioned Rs14,000 crore of bonds last week, which were the 7.83% 2018 for Rs4,000 crore, the 8.79% 2021 paper for Rs7,000 crore, and the 8.83% 2041 one for Rs3,000 crore. The cut-offs came in at 8.17%, 8.14% and 8.50% respectively. The government is auctioning Rs13,000 crore of bonds this week.

 The RBI bought Rs10,435 crore of bonds through OMO purchase auctions last week. The ones bought were the 8.07% 2011 paper for Rs267 crore at an yield of 8.17%, the 7.80% 2021 bond for Rs4169 crore at an yield of 8.24%, the 8.08% 2022 bond for Rs2997 crore at 8.28% and the 8.28% 2032 bond for Rs3,000 crore at 8.48%.

— The writer is editor, www.investorsareidiots.com, a website for investors