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The big bond reform

RBI raising limits for foreign investors holding government bonds is more significant than the rate cut.

So finally it’s done: the RBI cut rates. With inflation steadily printing lower, taking real interest rates to near record highs, and growth, at least in the organised sector, seeming sub-par, the cut wasn’t surprising, even if the magnitude was. As for the magnitude, if nothing else, a front-loaded cut effectively rules out uncertainty on rate decisions for several months — that is, unless global economic and market volatility worsens meaningfully. We can now hopefully focus on the real issues after months of unending skirmishes between the hawks and the doves, when it seemed, at times, as if the only thing holding back the Indian economy was the RBI’s reluctance to cut rates. This is not to trivialise the importance of the repo rate but to highlight the fact that the economic recovery has been sluggish for many reasons, and the RBI keeping its rate high is not even in  the top five in our view. To start with, the RBI cutting rates won’t automatically bring down interest rates for everyone. There are three interest rates that matter, not just one. The first, the repo rate, which the RBI uses for controlling interest rates in the economy, is the rate at which banks can borrow from the RBI. The second, the yield on government bonds, is the rate at which the government can borrow from the market, and is a benchmark for companies issuing bonds. And then there is the bank base rate (the SBI can be considered a benchmark), at which companies and individuals get loans from banks. While these three rates generally tend to move in the same direction, each has different drivers. The repo rate is now back to 2011 levels, but bank lending rates are as much as 1 percentage point higher than they were then (this is after the SBI cut rates post the RBI decision — other banks’ cuts have been much lower than the SBI’s). The primary reason for this is the growing inefficiency in a large part of the banking system (mostly in PSU banks), exacerbated by stress from unresolved bad loans. In fact, as per Credit Suisse estimates, if banks do cut lending rates by as much as the RBI cut the repo rate, profits for most would drop by 5 to 17 per cent. It is also unclear what the limited cuts in bank lending rates can do to revive the corporate investment cycle. Historically, corporate loan demand doesn’t correlate well with interest rates — that is, lower rates don’t drive more borrowing. It will also not, in all likelihood, relieve stress for over-leveraged companies: even if the entire repo rate cut were transmitted, the number of companies not able to pay interest on their outstanding debt would not change by much. That is because the debt burden is too high. High indebtedness at many business groups impairs their ability to invest in new projects and, in any case, as also seen in the Western world, if utilisation is low, as it is in many sectors in India, cutting interest rates doesn’t trigger any meaningful revival in investment activity. What accompanied the rate cuts, that is, the second half of the policy document, was more interesting both for the steps taken and the resultant signals. For the first time since the tempestuous middle months of 2013, when foreign investors stampeded out of Indian bonds, pressured the rupee and triggered a self-reinforcing near collapse, the RBI sharply raised the limits for foreign investors holding government bonds. These limits could have been raised almost a year back, when they were reached, but the central bank was apprehensive about global volatility around the time the US Federal Reserve raised interest rates from zero. The RBI has also allowed foreign investors into state government bonds for the first time. That despite its earlier fears, the RBI chose to do this before the Fed raises rates, demonstrates its confidence in the economy’s fundamentals when it comes to external balances. With a balance of payments surplus of nearly $60 billion last year, and a further surplus of $50 billion this year, India’s reserve build-up in the last two years has been the strongest in the world. Most other markets have seen reserves decline during this period. Such a relaxation of limits is also important to absorb external capital. Earlier, commodity-exporting countries, which had large current account surpluses, were the exporters of capital: a meaningful part of this capital was deployed by their sovereign wealth funds through equity markets. The recent fall in global commodity prices has dramatically changed the direction and nature of global capital flows. Surpluses now accumulate in economies like Japan, Germany, Korea and China, which export capital either through FDI or through pension and insurance funds, which are primarily bonds focused. Opening up of bond markets is, therefore, important to be able to receive such flows. This serves another purpose: more foreign buying should push down yields, further widening the gap between bank lending rates and bond yields. Lower yields are nudging corporations towards bonds, helping disintermediation of the banking system, and improving the depth and breadth of the bond market. This is a very important development for the economy, as long-term capital for infrastructure is best provided by the bond market. There is one segment of the economy that stands to benefit the most from the RBI’s actions: the retail borrower (home and auto loans). Not just through the drop in bank rates, but also lower bond yields that then translate into lower borrowing costs. Unlike for corporate borrowing, historically, lower rates have driven higher retail loan growth. Lastly, at the risk of stretching deductive logic a bit, contrary to the “government vs RBI” soap opera playing in newspapers, the central bank’s actions show greater trust in the government. While the government is focused on its fiscal deficit targets, front-loaded cuts by the RBI assume it will deliver, despite the upcoming implementation of the Seventh Pay Commission.

*The writer is India strategist, Credit Suisse.

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