A bond bubble has formed across the developed world, especially in the Eurozone. Sovereign bond yields in the Eurozone are at record lows irrespective of the debt profile of nations. Read our note on Bond Bubble on ECB QE. The Euro is down over 20% against the USD while the Japanese Yen is down 14% against the USD over the last one year. These export driven economies are benefitting from weak currency even as their central banks are pumping in more and more liquidity at record low interest rates.
Emerging markets are trying to devalue their currencies that are relatively strong to maintain export competitiveness. Central banks are lowering rates to reduce interest rate arbitrage flows into their economies. Read our note on competitive devaluation of currencies. RBI cut the Repo rate by 25bps in March citing the relative strength of the INR as one of the reasons for the rate cut.
The INR is one of the best performing currencies against the USD over the last one year. Read our currency market analysis for global currency movements. INR is helped by a low Current Account Deficit (CAD) and high capital flows. CAD was USD 26.2 billion in the April – December 2014 period while capital flows were at USD 61.7 billion. RBI has bought USD 41 billion to absorb the capital flows.
Capital flows are poised to continue at high pace in fiscal 2015-16 as excess global liquidity finds its way into higher yielding assets given record low yields across the globe. RBI will have to aggressively buy USD to absorb capital flows as weak oil prices coupled with low export growth lowers the CAD. RBI could end up buying USD 40 billion or higher in this fiscal year.
RBI added close to Rs 2500 billion of liquidity into the system through USD purchases in the April-January 2014 period. This liquidity infusion was negated by the government running a high surplus and by RBI selling bonds through OMO. Read our Liquidity Cheat Sheet for analysis of Liquidity Flows. RBI is likely to add similar amounts of liquidity through USD purchases in this fiscal year.
Managing the high liquidity that is pumped into the system will be the focus for RBI going forward. The tools the central bank will use for managing liquidity flows will be Repo Rate cut to bring down interest rate arbitrage flows, issue of MSS (Market Stabilization Scheme) bonds to sterilize liquidity and selling government bonds from its books through OMO (Open Market Operations) to manage its balance sheet. The monetary base rises as RBI buys USD and to negate that RBI will sell bonds from its own account.
The impact of the Liquidity Deluge will be a yield curve steepening as money flows into the short end of the curve on rate cuts. The yield curve is flat at present with one to thirty year government bonds all trading at similar levels of 7.75% to 7.85%.
Attend our Second Knowledge Workshop on Liquidity scheduled for the 22nd May at Sofitel BKC Mumbai to understand and analyse the effects and repercussions of high liquidity flows in an highly uneven global economic environment. Click here to register for the workshop.
RBI complained about lack of monetary transmission in the economy, as banks have not brought down lending rates post cumulative 50bps rate cuts since January 2015. One of the reasons banks are not lowering lending rates is that their cost of borrowing has not really come down since January. Three months and one year CD (Certificate of Deposit) have hardly moved from levels of 8.60% seen in January. The rate cuts have not filtered in to banks borrowing costs due to liquidity conditions tightening going into the year end.
Banks borrowed Rs 2475 billion from the RBI as of 31st March, up by Rs 1600 billion since January. Fiscal year end considerations coupled with government cash surplus has led to liquidity tightening considerably in March. Liquidity should come back into the system in April and that should enable banks to lower its cost of costs.