RBI has guided for a shift in policy to supporting growth from the earlier policy of containing inflation expectations. The central bank maintained policy rates status quo in its policy review on the 18th of December 2012 even as it spelt out its shift in policy stance starting January 2013.
RBI will look for a steeper yield curve going forward to support its growth stance. The current government bond yield curve is extremely flat with one, five, ten and thirty year bonds trading at levels of 8%, 8.08%, 8.15% and 8.40% respectively. The spreads between one and ten year segment of the curve is just 15bps while the spread between the ten and thirty year segments of the curve is 25bps. Such spreads are more indicative of economic growth coming off rather than growth rising as flat spreads indicate that long term bond yields are factoring in lower growth expectations and this lower growth expectations will lead to fall in inflation.
One of the reasons for the flat spreads is the tight liquidity condition that is prevailing in the market. Liquidity as measured by the bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI has been consistently negative for over two and half years and the system has been consistently borrowing from the RBI at repo rates. Repo rates at 8% levels are just 50bps since April 2012. Repo saw its highest levels at the beginning of calendar year 2012 at 8.5% as RBI raised rates to fight inflation expectations.
RBI will look to steepen the yield curve by lowering repo rates starting January 2013 and by looking to get liquidity into positive territory. The latter is becoming a problem for the RBI as despite CRR (Cash Reserve Ratio) cuts of 175bps (infusing liquidity of around Rs 140,000 crores into the system) over the last one year and government bond purchases of over Rs 100,000 crores in this fiscal year, liquidity is still deeply in the negative. Bids for repo were Rs 146,000 crores on the 17th of December 2012. RBI will have to undertake more liquidity easing measures for liquidity to come to normal territory and that is +/- 1% of NDTL (Net Demand and Time Liabilities), which is around Rs 65,000 crores.
RBI focus on growth will involve raising credit growth estimates for fiscal 2013-14. However for credit to grow bank deposits have to grow to fund the credit. Bank deposit growth has been lagging credit growth over the last two months leading to the incremental credit deposit ratio (ICDR) rising to 76% levels from levels of 20%. RBI has highlighted this in its policy review statement (widening wedge between deposit and credit growth) and will have to fix this issue through liquidity infusion.
Lowering the repo rates and improving liquidity conditions in the system will help short term yields to fall as markets borrow (lend?) at the lower rates. The fall in short term government bond yields will help lower lending costs for banks as they can lower deposit rates and can borrow cheaper funds from the market and the RBI (if necessary).
The corporate bond yield curve too will steepen on the back of RBI growth policy. One year, five year and ten year corporate bonds are trading at levels of 8.75%, 8.95% and 9% respectively and levels on one and five year corporate bonds should fall faster than levels on the ten year corporate bond leading to the yield curve steepening.