India’s central bank RBI kept its benchmark repo rate (under the LAF-Liquidity Adjustment Facility) unchanged at 4% for its April meeting, as strongly expected. The RBI also left the old Repo Rate (RR) unchanged at 3.35% (contrary to some market expectations), MSF (Marginal Standing Facility) and Bank Rate at +4.25% . But RBI has introduced a new LAF tool called SDF (Standing Deposit Facility), which is a reverse repo instrument with no collateral requirement (unlike the old RR, which requires collateral).
RBI will now accept excess liquidity (funds) from banks at +3.75% under SDF instead of FRRR (Fixed Rate Reverse Repo). Thus, RBI effectively indirectly raised the reverse repo rate and offered a higher risk-free return to banks for their excess liquidity; i.e. banks are now encouraged to park excess funds with RBI for higher risk-free return rather than risky lending. This will result in a more difficult financial situation.
As there is now excess system/bank liquidity around Rs.8T, it was becoming difficult for RBI to provide adequate collateral (GSECS/Government Bonds) to banks under the normal Reverse Repo (RR) window. Thus RBI introduced a special FSD to absorb excess bank liquidity at +3.75%. Either way, banks were already getting an effective RR rate of around 3.75-4.00% through a dynamic VRRR (Variable Rate Reverse Repo) auction. The overall impact was therefore quite limited. But this could be positive for banks as they will now get higher fixed/minimum returns at +3.75% RBI vs. +3.35% previously. RBI may use the FRRR (Fixed Rate Reverse Repo) tool to absorb excess bank liquidity in the future at its discretion and as the financial/economic situation develops.
RBI also released an official statement for SDF:
Introduction of the permanent deposit facility
In 2018, the amended Section 17 of the RBI Act empowered the Reserve Bank to introduce the Standing Deposit Facility (SDF) – an additional tool to absorb liquidity without any collateral. By removing the binding collateral constraint on the RBI, the SDF strengthens the operational framework for monetary policy. The SDF is also a financial stability tool in addition to its role in liquidity management.
Consequently, it was decided to institute the SDF with an interest rate of 3.75% with immediate effect. The SDF will replace the fixed rate reverse repo (FRRR) as the floor of the LAF corridor. The permanent installations, namely the MSF and the SDF, will be available every day of the week, throughout the year.
The fixed rate repo rate (FRRR) is maintained at 3.35%. It will remain as part of the RBI Toolbox and its operation will be at the discretion of the RBI for purposes specified from time to time. The FRRR and SDF will provide flexibility to the RBI’s liquidity management framework.
Restoration of the LAF symmetrical corridor
In 2020, during the pandemic, the width of the LAF corridor was widened to 90 basis points (bps) by asymmetric adjustments of the reverse repo rate to the policy repo rate. With a view to fully restoring the pre-pandemic liquidity management framework of February 2020 and taking into account the gradual return to normalcy of the financial markets, it has now been decided to restore the width of the LAF corridor to its pre-pandemic level.
With the introduction of the SDF at 3.75%, the political repo rate being at 4.00% and the MSF rate at 4.25%, the width of the LAF corridor is restored to its pre-pandemic configuration of 50 points. base. Thus, the LAF corridor will be symmetrical around the political repo rate with the MSF rate as a ceiling and the SDF rate as a floor with immediate effect.
The RBI maintained the repo rate for the 11th consecutive time in April, primarily to mitigate any negative ripple effects from Russia-Ukraine/NATO geopolitical conflicts/tensions and G7 economic sanctions, which may lead to stagflation as a scenario (lower economic growth, higher inflation and higher unemployment) for the global and local (Indian) economy. Without naming Russia or Ukraine, RBI said the two countries are major sources of various commodities, the disruption of supply of which can lead to persistent inflation, especially in the event of a prolonged oil boil in the United States. above 100 dollars.
Although RBI is currently not hostage to any particular rulebook, it has been behind the inflation curve for a long time and is practically treating 6.00% of the upper tolerance level as a target instead of 4.00%. The Indian economy was already in a stagflation-like scenario (lower economic growth, higher inflation and higher unemployment) even before COVID. Although RBI never admitted it, it now appears that RBI is very concerned about the stagflation-like scenario due to the Russia-Ukraine/NATO geopolitical disputes, ensuing economic sanctions and supply chain disruptions. . The resulting higher inflation and lower GDP growth can indeed cause stagflation and even outright recession (after the RBI tightens).
It now appears that with the exception of the BOJ/Japan, the surge in inflation is a major headwind for all systematically important global central banks, including the Fed, ECB and BOE. High inflation is now the dual problem of higher demand and lower supply. As a central bank only has political tools to control the demand side of the economy (by tightening), not the supply (which is controlled by the administration, legislators and various geopolitical events). Thus, RBI can also control inflation by slowing the economy/demand through calibrated tightening without causing an outright recession. Until now, RBI was unwilling to slow down the economy and control inflation as the focus was on growth. RBI believes that there is sufficient spare capacity in the economy and therefore an ultra-loose monetary policy (by Indian standard) is needed.
But RBI is now shifting its focus/priority to price stability rather than growth, as runaway inflation will lead to lower discretionary (non-essential) consumer spending and ultimately lead to lower GDP growth. Normally, like all other major central banks, the RBI also follows the real or even prospective policy action of the Fed to keep the real bond yield differential attractive enough so that angel investors continue to invest in Modinomics (history growth in India). But this time, despite the +0.25% Fed hike in March, the RBI is suspended in April as US inflation is now around 8% versus 6% in India. The real interest rate is now around -2% in India compared to -7.5% in the United States
Either way, the Fed could rise @ +0.50% six times from May to December 22, and the Fed rate would be +3.50% by the end of 2022. The Fed will also accelerate its QT ( balance sheet reduction) @ 95B/M. Thus, yields on USD and US bonds have already skyrocketed and in the future may rise further. RBI must match the Fed and can therefore also start take-off (gradual rate hikes) from June.
According to Taylor’s rule:
Recommended policy rate (I) = A+B+(C+D)*(EB) =1+4+ (1.5+0)*(6-4) =1+4+1.5*2=1+ 4+3= 8%
Here for RBI:
A=desired real interest rate=1; B= inflation target =4; C = allowable inflation target deviation factor = 1.5 (6/4); D = allowable factor of output target deviation from potential = 0; E= Actual CPI=6
In accordance with Taylor’s rule, which Fed policymakers typically follow, assuming India’s ideal real interest is 1%, the RBI interest/policy/repo rate should be +8, 00% against +4.00% currently. But given the reality of the situation on the ground, the RBI could climb to 5.5-6.5% by FY23, depending on the actual path of inflation, which could significantly exceed + 6.00% in the next few days due to rising fuel and food costs. as well as underlying inflation. So, depending on actual inflation and the growth trajectory, RBI could start the takeoff by rising +0.50% in June to match the Fed’s +0.50% rate hike action. . Then RBI may rise @ +0.25% or +0.50% in the rest of the 4 meetings (Aug/Sept/Dec 22 & Feb 23) depending on actual Fed rate hike action and of inflation.
At the end of the line
India already pays around 45% of its basic income in the form of interest on public debt compared to 9% for America, 15% for Japan and 5.5% for China. So, India cannot afford too high a bond yield and therefore needs to control inflation and the RBI needs to be ahead of the curve tightening faster in a balanced way; otherwise, RBI’s credibility could be at stake.
For the future, whatever the story, technically The future must now maintain more than 18000 levels for 18200/18320-18400/18600; otherwise, holding below 17950, it could fall to 17600/450-17300/17000 and further 16875/16700-16300/15700 in the coming days (if the Russia-Ukraine/NATO geopolitical conflict escalates further)