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* The growth-centric budget has implied elevated market borrowings, further spooking the bond market which was already reeling under pressure since January on fears of an apparent liquidity withdrawal. The unintended financial tightening amid a nascent growth recovery is neither optimal nor desirable at current juncture. The upcoming RBI policy will likely to be vociferous on communication on being the heavy-duty balancing factor in Gsec demand-supply ahead. We reckon there seems much ado about fiscal dominance of the monetary policy in the current context and monetary policy complementarity is presently needed.

* In addition, on the liquidity management front, the (mis)communication loop between the RBI and markets needs to be broken. The policy intent has been to tackle the liquidity asymmetry than to tighten its state, and to fix misplaced risk bets in money markets. We watch out for actions - such as 1) defined OMO calendar and secondary market G-sec buying; 2) no increase in variable reverse repo (VRR) quantum; and 3) maintenance of adequate system liquidity - as strong policy signals. However, we reckon the RBI will continue to strive fixing the artificially skewed yield curve and maintain its preference for curve flattening. We also watch out for the introduction of tools such as MSS bonds and/or standing deposit facility (SDF) ahead.

A growth-centric budget has come at a cost…

The FY22 budget has struck all the right chords, ensuring that the underlying fiscal impulse does not become pro-cyclical ahead. However, its cost has come in the form of elevated Net/Gross market borrowing at Rs9.25tn/Rs12.05tn. This has further soured G-sec yields, which have been reeling under pressure since the fear of supposed liquidity tightening by the RBI hit the markets in early January (see “Liquidity normalization ≠ Liquidity tightening”, Jan 12,2021). The pressure is now felt across the yield curve unlike recent weeks where the pressure was shorter-tenor centric. The 10-yr yield has comfortably breached the psychologically crucial 6% mark. Against this backdrop, the upcoming MPC will assume importance to gauge the central bank’s reaction function ahead.

“Need” to reverse unintended financial tightening but…

Honestly, there is no straight answer as to how to reverse the unintended financial tightening which started with shorter tenor and has now engulfed the whole curve. We are still far from that state which is neither optimal nor desirable at current juncture. With elevated borrowings and policy rates likely having bottomed out, the appetite for duration risk on G-sec will likely fade. Thus, RBI support in the form of vigorous OMOs will be required to maintain demand-supply balance and pressure on the longer end of the curve. Further, we believe that the liquidity withdrawal will be a gradual process. We reckon current liquidity deluge is not necessarily feeding into present inflation dynamics as the credit offtake remains sluggish. Any premature tightening of market rates could also be counter-productive and instead lead to more speculative FX flows and also hurt nascent growth recovery and credit offtake, while increasing the RBI’s problem of plenty.

…“how” remains a challenge

We would watch out for a more vociferous RBI on OMOs/OTs in the upcoming policy. On the liquidity management front, we maintain that the policy intent was to tackle the liquidity asymmetry than to tighten its state, and to fix misplaced risk bets in money markets. (see “That Taper Tantrum like feeling…”, Jan 19,2021). Thus, the (mis)communication loop between the central bank and markets needs to be broken. Actions such as 1) not increasing the quantum of VRR and 2) maintenance of adequate system liquidity could send a strong signal to markets to align them back to the RBI’s intent. However, we reckon that RBI will continue to strive fixing artificially skewed yield curve and maintain its preference for curve flattening. We watch out for possible action in the form of (including any delay) an expected 1% CRR normalization (which should withdraw Rs1.6tn from the system), MSS bonds and/or SDF introduction, among others.

Much ado about fiscal dominance of monetary policy

There is much ado about the fiscal dominance of monetary policy in the current context where the RBI may have to absorb more than 40% of market loans in FY22E. However, we believe that the countercyclical fiscal stance is indispensable at the current juncture to sustain demand and mitigate the long-term costs of the crisis. Monetary policy can complement these efforts, amid its current constraint effective lower bound of policy rates. In times like these, it may not be prudent to limit fiscal policies “today” to protect monetary dominance “tomorrow”. On the contrary, using fiscal and structural policies more actively in the current environment may foster central bank independence. This is because such policies may boost potential growth and thereby increase the monetary policy space in the future. A lower welfare cost of public debt may be needed when public funds are used for investments addressing growing economic externalities. Although this should not be confused with modern monetary theory (MMT), which denies the government’s intertemporal budget constraint. We reckon that once the sustainable growth path, the fiscal policy should take a backseat again and regain the policy room.

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