Negative real interest rate for savers behind RBI's govt bond buying plan

Central bank acknowledges further interest cuts unlikely as a recent rollback of small savings rate cut showed.

The announcement of government securities acquisition programme (G-SAP) by the Reserve Bank of India (RBI) during Wednesday’s monetary policy announcement is akin to the quantitative easing (QE) by the central banks of developed countries.

Quantitative easing is large scale buying of financial assets like corporate and government bonds or even stocks. Such a move increases the money supply and brings down long term interest rates. Lower cost of borrowing then stimulates economic growth.

In developed nations, the interest rate is near zero: one of the main reasons why central banks resort to such asset purchases to boost economic growth.

The zero-interest rate policy (ZIRP) was one of the prominent policies of the US Fed last year in response to the Covid-19 pandemic. ZIRP in the US means the Fed has set the lower bound of the Fed Fund target range to 0.00%. Following the global financial crisis of 2008, ZIRP lasted for seven years, from 2008 to 2015.

In India interest rates are not at near zero, in fact the repo rate is now at 4%. Interest rates of some of the popular retail lending rates like home loan and car loans of commercial banks are linked to the repo rate. 

The real interest rate for savers is in the negative territory for more than a year, a reason why the central bank is finding it difficult for lower the repo rate further as commercial bank will have to pass on the interest rate cut by reducing deposit rate to compensate for lending rate reduction. This was the reason the bond purchase prorgamme announced in a bid to manage interest rates instead of an outright repo rate cut.

“The assured liquidity support is a clear resemblance to Developed Market central banks. Thus, the RBI has nicely dovetailed a liquidity strategy specific to Indian context,” said Soumya Kanti Ghosh, Group Chief Economic Adviser, State Bank of India.

Since real interest rates are negative, for commercial banks and other lenders that offer fixed deposit facilities further reduction in interest rate is almost ruled out. HDFC, for example: the mortgage lender that is allowed to offer fixed deposit products, hiked deposit rates by 25 bps on March 30. (1 percentage point = 100 bps.)

Recently the government had announced a deep interest rate cut in the small savings rates amid assembly elections in four states and one union territory but reversed its decision quickly. After widespread criticism, the finance minister said the rate cut announcement was due to ‘oversight’. “The Narendra Modi government understands the election economy,” said a senior banker on the condition of anonymity.

India’s gold import in March surged 471% from a year ago to a record of 160 tonnes indicating a shift in investors preference towards the yellow metal from financial assets.

In the G-SAP 1.0 programme, the central bank said it will buy government securities worth Rs 1 lakh crore in the current quarter (April-June). The first purchase of government securities of Rs 25,000 crore under G-SAP 1.0 will be conducted on April 15, 2021. The central bank was conscious to call it a first version to keep possibilities open of future versions, RBI governor Shaktikanta Das indicated in an interaction with the media.

The G-SAP is the first time the central bank has committed its balancesheet to the monetary policy. Earlier bond purchases were decided depending on evolving liquidity conditions and other factors. This time, what the central bank is saying is this: Come what may, irrespective of market conditions, RBI will buy the amount of bonds that it has promised.

“We are not leaving anything to the market to guess on the quantum, the timing or the demand or anything else. And this is a commitment to fund it from the RBI balance sheet itself," RBI deputy governor Michael Patra said during interaction with the media. Patra also said that the G-SAP programme is independent of the other liquidity management tools – that is OMOs, operation twist etc will also continue alongside.

Bond markets cheered the move with yields on the 10 year benchmark dropped after the announcement. The hardening of bond yields following the Union Budget announcement of Rs 12 lakh crore borrowing for the current financial year has made the central bank worried. In addition, uptick in crude oil prices also put upward pressure on yields.

“This [G-SAP] has been received positively by the market with the 10Y benchmark yield correcting by as much as 7 bps post announcement to an intra-day low of 6.05%. As such, we expect the 10Y benchmark G-sec yield to trade between 6.10-6.25% in the near term, while approaching 6.50% level by Mar-22,” economists at Yes Bank said in a note.

The side effects of this bond purchase programme was felt in the foreign exchange market. The rupee crashed 113 paisa or 1.54% in its steepest single day fall in 20 months to end the day at 74.55 a dollar.

“A defined Gsec purchases-led liquidity infusion via GSAP is de facto a secondary QE of RBI.  Moreover GSAP will be happening in conjunction with existing liquidity tools like OMOS, LTROs etc…and not as a substitute of the same,” said Madhavi Arora, lead economist, Emkay Global.

“This will imply massive narrow money growth and primary liquidity which is clearly going to put depreciation pressure on INR,” she added.  

The central bank was worried about the rupee’s appreciation which was also discussed at a meeting with banks a couple of weeks back. Till end March, except for the last trading session, rupee was the best performing Asian currency and the only one to strengthen against the dollar in 2021.

“We remain bearish on the INR and maintain our USD-INR target at 76.50 by end-2021. Sharp negative INR reaction was likely driven by positioning; balance sheet commitment contributed at the margin," economists at Standard Chartered Bank, India said.

"It is probably too soon to start suggesting a direct linkage between the G-SAP program and rupee depreciation. One, it isn’t clear yet whether the program implies an extra expansion to the central bank’s balance sheet versus what had been envisaged before, or whether the same amount of expansion now will proceed through a wider toolkit, " said Suyash Choudhary, Head Fixed Income, IDFC AMC. 

"While ceteris paribus a larger central bank balance sheet should translate into a weaker currency, the fact of the matter is that there are many other factors in play including the effectiveness of policy tools used in supporting growth and investor perceptions on whether such tools are being used responsibly, " Choudhary told Business Standard. 

Since it is not known if the bond buying assurance was rolled out keeping in mind the recent strengthening of rupee, one can assume the depreciation of the Indian currency is an unintended consequence of quantitative easing, in a positive sense.