Tuesday, March 23, 2010

Do Policy Rates really matter right now?

Interest rates are typically of two types. Ones which are decided by Regulators such as the RBI are called Policy Rates. In India at the moment, the RBI uses the Repo and Reverse Repo at Policy Rates. These are the rates at which the RBI lends and borrows from eligible market participants respectively. Other than Policy Rates, almost all rates are decided by market participants through methods of price discovery and are called market rates.

Policy Rates are an important monetary policy tool and are often used by policy makers to influence the direction and pace of the economy. Interest rates are raised to cool an economy and lowered to provide a fillip in bad times. These changes are usually gradual and are looked upon as economic fine tuning by the Central Bank (RBI, in India's case). Then there are times when dramatic movements are needed. These are typically times when imbalances are created, hurting the economy, needing an immediate resolution.

Market rates are influenced by Policy Rates and should ideally move in lockstep. When this happens, transmission of monetary policy is said to be near perfect, and there is a distinct possibility that monetary policy aims will be achieved. However, market rates are also influenced by other factors such as Liquidity, Demand & Supply and Reserves that Banks needs to hold with the Central Bank. And as a result, monetary policy transmission is diluted as also the possibility of it's aims being achieved. Normally, a Central Bank would anticipate this and try to compensate by calibrating it's moves accordingly.

Transmission of monetary policy is also affected by the belief market participants have in the stability and predictability of the Policy Rate. For this reason, most Central Banks strive to maintain a high level of transparency in their Policy Rate deliberations and prefer to have one Policy Rate. In India, we have two Policy Rates, the Reverse Repo Rate at which the RBI borrows from market participants and the Repo Rate at which the RBI lends to market participants. Also, the amount of money that the RBI lends to market participants is restricted to the excess Government Debt owned by these participants. Right now, and for some time now, the difference between these two policy rates is 1.50%. After the recent hike, the Reverse Repo rate is 3.50% and the Repo rate is 5.00%. This difference between the Repo and Reverse Repo Rates of 1.50% is called the corridor for overnight rates which, depending on the level of liquidity in the market can settle anywhere between 3.50 - 5.00%. And if market participants need to borrow more than their excess holding of Government Debt, there is no limit to which the overnight rate can rise. This was experienced in October 2008, when extreme measures instituted by the RBI resulted in the overnight rate varying between 0 - 100% in the space of 15 days. From a prespective of stability and predictability, this is probably the worst arrangement for Policy Rates.

This uncertainty is reflected in the spread that market participants charge on long term investments. If the overnight rate is predictable, the spread will be low and if there is a high level of uncertainty, the spread will be high.

At this point in time, when there is a small liquidity surplus in the market, the overnight rate is close to 3.50%, the Reverse Repo Rate. Despite this, the yield on 10 year Government Debt is over 8.00%, a spread of 5.50% which is more than twice the long term average. This is a reflection of fear in market participants that even a small change in market liquidity could send the overnight rate to 5.00%, the Repo Rate. The fact that the overnight rate can increase by 1.50% without any policy action of the RBI is reflective of the fragility of the overnight market and contributes to high market yields despite an apparently accomodative monetary policy.

Then is the matter of demand & supply. If the Government needs to borrow more than the market's ability to lend, spreads will rise and if Government borrowing is restricted to reasonably low levels, spread will fall. The market's ability to lend is a function of participants in the market and liquidity available with these participants. In the Indian context, the major participants in the market are Banks, Insurance Companies, Mutual Funds and Primary Dealers. The first two are long term investors as the nature of their funds allows them to invest in that manner. Investments made by Mutual Funds have an element of uncertainty in them, as the funds available with them are a function of market liquidity. Primary Dealers are special entities set up under the aegis of the RBI with the intention of easing the borrowing process for the Government. They are essentially traders, buying Government debt directly from the RBI with the sole intention of selling it to other participants.

The Union Budget for 2010 - 11 placed the Government's gross borrowing at Rs. 457,000 crs and Net Borrowing at Rs. 345,000 crs. If one were to take interest payments by the government into account, the net liquidity drain the market would experience as a result of these borrowings will be in the region of Rs. 235,000 crs. This amount is exceptionally large given the country's bank deposit base and it's expected growth. Market partiipant's perceive the liquidity impact of this borrowing to be significant enough to demand a premium on the normal yields that would be available if this wasn't the case.

For the reasons mentioned above, yields or interest rates for the safest investment option in India remain at elevated levels. It is only natural that interest rates charged by Banks to commercial enterprise will also be high. In fact, despite the fiscal stimulus announced by the government and as mentioned earlier, an apparently accomodative monetary policy, interest rates charges by Banks to Small and Medium Enterprises have remained between 13 - 14%. This gap in the transmission of monetary policy is as much a failure of the RBI as faulty monetary policy itself.

The solution to this lies in tackling the core issues themselves.

Forthe first part, the stability and predictability of policy rates, the RBI needs to act immediately and reduce the size of the corridor for overnight rates. It can be done immediately without hurting the market or causing unnecessary euphoria by reducing the Repo rate by 0.50% and increasing the Reverse Repo rate by 0.50% simultaneously. This would reduce the size of the corridor to a more acceptable 0.50% without giving a clear interest rate signal to the market when none is intended.

With regard to market liquidity, the RBI has three options which can be undertaken individually or together. The first would be to increase the amount of liquidity available with the current set of market participants. This can be achieved by conducting Open Market Operations to buy Government Debt from market participants. The second way would be to reduce the amount of government debt sold to the current set of market participants by buying a part of the government's fresh borrowings directly from the government. This is called Private Placement. Both these options are frowned upon by economists as they amount to a monetization of the government's deficit.

The third option, which is the most viable at this point in time, would be to expand the set of participants. For many years now, Foreign Institutional Investors have exhibited a high degree of interest in investing in Indian Government Debt. This interest has not been capitalized upon by the RBI due to a vague fear that allowing FII participants in the government debt market could be the tantamount to issuing debt to foreigners or borrowing overseas. The operative difference in these situations is the currency in which the debt is denominated. If FIIs are allowed to invest in the Indian debt market, all the debt they buy will be denominated in Indian Rupees. In case of foreign issuances, this debt would be denominated in a foreign currency, which results in increased foreign exchange liabilities for the nation. But since this isn't the case with FIIs investments in the existing debt market, this conern can be discounted. Another fear could be the influence these FIIs would exert on the domestic debt market if they were allowed unfettered access. This can very easily be remedied by not allowing unfettered access.

Even currenty, FII investments in the debt market are regulated by limits set by SEBI in consultation with the RBI. This limit is divided into a sub limit for investments in government debt and another for investments in corporate debt. These are currently at USD 5 bln and USD 15 bkn respectively. To put this in context, total outstanding government debt is approx. Rs. 1,785,000 crs or USD 391 bln. The current limit for FII investments in government debt is just over 1.25% of the market's size. An increase in this limit to a more realistic 15-20% would allow FII participation without dominance. Also, like some other countries, a minimum residual tenure can be specified for these investments which restricts FII investments to securities which have more than say, 7 years to maturity at the time of purchase. This would prevent FIIs from playing on the short term interest differentials and / or the currency market.

From the timing perspective, it is absolutely imperative that these measures are put in place immediately before the new borrowing season starts on April 1. Apart from easing the strain on market liquidity, these measures would improve the effectiveness of RBI's monetary policy actions by improving transmission. They would also provide participants with market conditions favorable to increased volumes, greater efficiency and improved price discovery.

Without these measures, the RBI's runs the risk of being completely ineffective in it's policy actions, resulting in chaotic domestic debt market conditions. There can be nothing more disastrous for the Indian Economy right now.

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