Wise or adventurous: How to read RBI policy action amid evolving geopolitical risk?

In usual times, RBI sets the tone for interest rates through its benchmark repo and reverse repo rates. The market then takes the cues from these rates to decide its course on the yield curve. That is a typical text-book style functioning of bond markets. But there are times when the market takes the mantle from RBI to set the direction for the interest rates. Currently, we seem to be in one such time with RBI falling well behind the curve.

Since the time RBI reduced the repo rate by over 120 bps during the period of Feb-May 2020, the repo rate has stayed put at 4%. The same is the case with a reverse repo with its rate ruling at 3.35%. But, of late, bond markets have refused to buy into this stability.

Looking at the ten-year Gsec yield, it hardly paints a stable picture that RBI is projecting through its repo rates. Since last October, it has sharply moved up by over 100 bps reflecting market’s staunch refusal to fall in line with the RBI’s accommodative stance.

In fact, the yield went all the way up to near 7% immediately after the presentation of the budget, before cooling off to the current level of 6.75%+ (as on Feb 24) level on a surprising (and adventurous to many) dovish stance of RBI in its latest policy announcement post the budget.

There is a justifiable reason why markets are refusing to toe the RBI line. Besides the inflation scare, the latest budget has also added to the market’s ire on the borrowings. Here is how it stacks up.

From the equity market’s point of view, this budget has been a success, especially if one goes by the stock market’s response in the days following the budget. It has lapped it up with cheers because of the budget’s focus on capex and growth. There is nothing in the budget fine print to upset the equity markets. Given the capex and growth push, the economy facing stocks in the broader space will do very well in the coming months.

In effect, the budget is going to push further the economic momentum that the country is already witnessing on account of the turn in capex, property, credit and export cycles. But if one looks at it from the bond market’s point of view, the picture is not all that rosy.

If there is any risk from this budget, it is likely to come from the bond market. During the budget presentation, there is one number which the bond markets weigh anxiously is the government’s borrowing level. This time, the large borrowing number in the budget (Rs 11.51 lakh crore net borrowings) for this year came as an unpleasant surprise to the bond markets. Bond markets were not prepared for this huge increase (from Rs 9.67 lakh crore last year). Also, the bond markets were expecting some kind of tax benefits to FPIs so as to expedite the inclusion in global indices. There was no such tax concession announced in the budget.

Now that there is going to be a delay in bond inclusion, the market is expecting this large borrowing to put pressure on 10-year Gsec. On that expectation, the yield spiked by over 30 bps (in the days following the budget), only to cool off to a much lower level post the RBI’s dovish policy announcement.

Will this cool-off be temporary? Should one be alarmed by these large borrowings?

One should certainly be worried if the packed-up borrowing calendar pushes up the 10-year Gsec yield in a disorderly fashion. But, given the ultra-conservative nominal growth projections in the budget, this risk is unlikely to play out.

In our view, the government will have a lot of headroom to manage the fiscal space because of the extraordinary cushion in the budget numbers. Look at the nominal growth as per the budget. It has assumed about 11.5%, which is an extremely conservative number. If one takes the Economic Survey as the cue, the real GDP growth as per the survey is likely to be 8.5% for FY23. If one adds the most likely inflation number, one will get a much higher number for nominal GDP growth. As a result, the government in all likelihood will have a lot more flexibility to alter the borrowing plans as the year unfolds, if the bond yields move in a disorderly fashion.

Even in the current year (FY22), the government had originally estimated to borrow around Rs 9.67 lakh crore against which the revised estimates are likely to be only Rs 8.75 lakh crore. While the government will have a lot of leeway in managing the borrowing calendar as cited above, new geopolitical risks such as the Russia-Ukraine situation could play a spoilsport. If this conflict plays out for an extended time, it will have the potential to upset the inflation/interest rate dynamics for India from pressure points that are fed through elevated oil and commodity prices.

In summary, in the context of these evolving risks, it is rather surprising that RBI chose to keep the accommodative stance with a super dovish tone in its latest policy pronouncements. Only time will tell whether RBI has been wise in its move or audaciously adventurous in its accommodative stance. Interesting times to watch out for!

The author is Founder, CEO & Fund Manager, TrustLine Holdings. Views expressed are personal.