Policy Rate: Only an Ingredient, Not the Dish

By Nishi Daas (Founder Director, Anvayins) Nishi.Daas@anvayins.com

The din for a rate cut seems to get louder by the day. Many in the Indian financial market were expecting a substantial cut in the policy rate by RBI in its announcement on March 16, 2020, citing similar action by major central banks around the world in response to the Covid-19 crisis. The general belief has been that a reduction in policy rate would provide the necessary impetus and confidence in the fight against the marauding virus.

While an expectation of rate cut is not out of place, it may not be prudent to overemphasise its importance in the present circumstances. A look at the response of the US bond market to Fed’s rate action is a case in point. The central bank slashed rates twice over the last few weeks for an aggregate of 150bps. Yet, the 10yr US Treasuries have moved up by almost 60bps to about 1.20%. Notably, contrary to usual market trends, the uptick in yield has coincided with a period of equity sell off.

The reason is the severity of risk aversion that seems to have set in. Cash spreads of US investment-grade credits have widened almost 150bps during the period while high yield loan prices have slipped by as much as 3 cents in a single day – a move that typically is seen over a whole year. Loans that used to trade in the range of 98-101 are now available at 80 cents to a dollar.

The Indian markets too have witnessed a surge in bearish sentiment with corporate bond spreads having widened as much as 60bps across the curve. Furthermore, there is no assurance that a reduction in policy rate will be transmitted by banks as they stare at mounting delinquencies in their portfolios in the aftermath of the current shutdown. If anything, the main beneficiary of a rate action, whenever it happens, would be the government itself as it borrows in the market to fund the stimulus, not necessarily the users of the capital.

Rather than reduce policy rates, RBI has preferred to enhance liquidity in the system. While the liquidity at more than Rs. 3L crore was already ample prior to the injection, the move was as much to create a war chest as it was to offset any spike that could result from the forex swap initiated to protect the currency.

RBI’s move to shore up liquidity mirrors that of its counterparts in the developed markets. The Fed has promised an infusion of about USD 1tn over the next three months to fight the effect of its shutdown. Similarly, the ECB has committed to a 750bn stimulus package. The capital is being used by the respective governments to support specific segments that are most affected by the crisis. For instance, UK has announced sovereign guaranteed facilities of GBP 330bn or 15% of the country’s GDP to small businesses to tide over the situation. The American government intends to make cash payouts to its citizens for an aggregate amount of USD 250bn.

In India, many sectors of the economy such as hospitality, leisure, retail, aviation, tourism amongst others are being ravaged by the shutdown imposed by the government. Many of them suffer not just liquidity but solvency stress. While a rate cut would help, sector specific solutions are the need of the hour. Getting banks to temporarily enhance working capital limits to meet the most critical overheads, according priority sector status to loans extended to these sectors, offering tax holidays to borrowers are some of the ideas that the task force set up by Prime Minister Modi may want to consider.

Emerging markets are facing difficult times. Countries like China and India that were struggling to recover from low growth rates have been dealt a body blow by this disruption. Even after China has declared successful containment of the disease, it has not been able to ramp up its capacity utilization beyond 40-50%. Despite a drastic fall in crude prices, the currency is under significant pressure because of flight of portfolio capital. While a rate action is an important tool in a sovereign’s fight against the disruption, it will be effective only if synchronised with measures specific to the challenges of the economy.

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