Despite the 135bps rate cut delivered by the RBI in the current easing cycle, the sovereign yield curve continues to remain steep. This is an impediment to transmission. Since the Indian sovereign curve is not very active across maturities, the 10y benchmark bond plays a very crucial role. The yield on the 10y determines the borrowing cost for states and corporates. With concerns of fiscal slippage, bonds have not rallied despite the rate cuts. The challenge for the central bank therefore is to flatten the yield curve to ensure transmission. It cannot resort to OMOs as the system liquidity continues to remain in surplus by over Rs 2 lakh cr and therefore the use of OMOs which is essentially a liquidity management tool cannot be justified. The system liquidity has continued to pile up on account of incessant FX purchases by the RBI to bolster it's FX kitty. Outright purchase of government securities would be tantamount to monetization of debt and would raise more than a few eyebrows. The alternatives that could be considered are:
1) Resorting to something like an operation twist wherein the Central bank sells shorter term securities and buys longer term. Such a move would be liquidity neutral. While a flatter curve is generally negative for banks, it would encourage more Prudent ALM practices by NBFCs.
2) With sovereign bond issuance being ruled out, the other alternative is to induce greater FPI participation in our bond market. Foreign investor participation in our bond markets is relatively low compared to other EMs such as Indonesia. This could be the right time to open up the bond markets further by becoming a part of a global bond index in a phased, calibrated manner.. A key impediment here is the extremely high FX hedging cost. Despite the central bank refraining from paying forwards to sterlize liquidity infused through FX purchases, forwards beyond 2y continue to remain elevated. The MIFOR-OIS spread continues to remain elevated due to dearth of receiving side flows in tenor beyond 2 years. The RBI can probably do a Buy-Sell swap 2y over 5y to flatten that part of the forward curve. However, this would encourage more participants to borrow offshore and the RBI has not been too keen on this in the past as it would increase our external debt.
Besides structural reforms, in order to increase the effectiveness of monetary policy it is imperative to reduce the term premium. It would reduce the cost of borrowing for Long gestation capital intensive infrastructure projects and would facilitate a pick up in CAPEX cycle.
We may see the RBI address this conundrum in the upcoming December monetary policy.
We put together our take on the major domestic and global factors driving risk sentiment over the medium term with special emphasis on political developments, monetary policy outlook and fiscal policy implications.
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