Our take on RBI's response to COVID-19

Morningstar Investment Management team shares its perspective on the measures announced by the central bank today.
By Morningstar Analysts |  27-03-20 | 
 

The RBI governor, in his recent press conference, had assured markets that the RBI is closely and continuously monitoring the rapidly evolving global situation and will take all necessary measures to ensure that money, debt and forex markets remain adequately liquid and stable and continue to function normally.

In light of the ongoing Covid-19 outbreak and consequential country-wide lockdown, the RBI preponed its MPC meeting.  Moreover, it announced a host of measures today to infuse liquidity in the banking system, improve monetary transmission & credit flow, ease financial stress, and improve price discovery in the forex market.

  1. MPC decided to reduce the policy rate by 75 bps to 4.4%
  2. Widen the existing policy rate corridor from 50 bps to 65 bps, with this the reverse repo rate stands adjusted at 4%
  3. CRR cut by 100 bps to 3%. This will infuse INR 137,000 crores uniformly into the banking system
  4. Banks can borrow overnight by utilizing 3% of SLR. This will infuse additional Rs 137,000 crores of liquidity
  5. Targeted Long-Term Repos (or TLTROs) of up to three years for a total amount of up to Rs 100,000 crores at a floating rate linked to the repo rate
  6. Banks to allow a moratorium of three months on instalment payments of all term loans outstanding as of Mar 1, 2020. This will not impact the credit rating of the borrower.
  7. Deferment of interest on working capital facilities by three months
  8. Permitting banks to deal in offshore non-deliverable Rupee derivative markets
  9. Deferment of net stable fund ratio and last tranche of capital conservation buffer by six months

The stance continues to be accommodative as long as it is necessary to revive growth and mitigate the impact of coronavirus (COVID-19) on the economy, while ensuring that inflation remains within the target. Along with measures announced today, the RBI, in the last couple of weeks, has already announced LTROs worth Rs 25,000 crore, OMO purchase worth Rs 25,000 crore and two sell-buy US dollar Indian rupee swap worth $2 billion each.

10-year benchmark G-sec yield fell 18 bps intra-day, although yields bounced back with 10-year benchmark closing at 6.14%. Measures announced today should help in stabilizing the money market, and short-term rates, which saw increased volatility as the demand for cash increased.

Corporate bond yields have hardened significantly in the last few days, mainly due to demand for cash amid lockdown clubbed with financial year-end pressure. With this, the corporate bond spreads have widened and are currently trading above their long-term averages. One needs to be mindful of the current stress in the credit market and the potential downgrades and defaults amid slowdown.

Our Take

Over the last couple of weeks, we’ve seen many governments and central banks across the world announce measures to support their economy. Both monetary policy and fiscal policy are important levers in the toolkits for governments, especially given monetary policy is potentially out of ammunition as most major central banks have already cut rates aggressively leaving policy rates close to zero, and are resorting to large scale bond purchases (OMOs in the Indian context). Globally, governments and central banks are going all out to stabilize the markets and support the economy as it is hard to quantify the Covid-19 impact on the global economy in the near term. The growth outlook remains extremely weak in the near term, with a high probability of a recession in many economies.

Most of the high-frequency lead indicators would suggest a significant growth slowdown/contraction in the Indian economy over the coming months amid a 21-day country-wide lockdown. Mainly, sectors such as tourism, airlines, trade, hospitality, and now manufacturing activity are severely impacted due to local and global travel restrictions and lockdowns. Supply chain disruption (imports from China & South Korea), a sharp drop in consumer spending, travel restrictions, and availability of credit to MSMEs would have a significant near term bearing on the economy. A sharp fall in crude oil prices should bode well for India resulting in lower import bills but the impact on inflation would depend upon how much of it is passed on at the retail level - at this point the fall in domestic pump prices has been marginal, instead duties have been increased!

The central bank has been trying to optimally utilize available tools at disposal to support growth, improve liquidity, monetary transmission, and flow of credit. Along with the traditional use of policy rate, the RBI has announced additional measures to help banks in lowering their cost of borrowing and reduce lending rates. The transmission of lower policy rates saw some improvement in recent months, with banks moving to external benchmarking. However, surplus banking system liquidity has so far not translated into higher credit growth, mainly due to weak business and consumer sentiments. With TLTROs, RBI is providing adequate liquidity up to three years at the prevailing low repo rate and widening of policy rate corridor should further incentivize banks to lend money rather than park it with the central bank.

Interestingly, RBI has directed banks on the utilization of monies raised via TLTROs and asked them to deploy in purchasing investment grade corporate bonds, commercial paper, and non-convertible debentures over and above the outstanding level of their investments in these bonds as on March 27, 2020. Banks shall be required to acquire up to fifty per cent of their incremental holdings of eligible instruments from primary market issuances and the remaining fifty per cent from the secondary market, including from mutual funds and non-banking finance companies. Investments made by banks under this facility will be classified as held to maturity (HTM) even in excess of 25 per cent of total investment permitted to be included in the HTM portfolio. Exposures under this facility will also not be reckoned under the large exposure framework.

The objectives of this step appear to be two-fold – 1) ease liquidity pressures in the secondary corporate bond market, which has seen a sharp jump in yields across rating buckets over the past couple of weeks and 2) ease borrowing pressures for investment grade companies. Further, by including the investments in the HTM bucket, the RBI wants to discourage banks from actively trading these securities in the secondary market.

The economic package worth Rs 170,000 crore announced by the government yesterday, which includes cash transfer and food security, would provide support to the rural and unorganized sector. This, along with compliance-related measures announced a couple of days back should possibly address the immediate near-term slowdown in demand and credit cycle.

The global growth slowdown amid the covid-19 outbreak casts doubt on the Indian growth story in the near term. Although, over the long-term, we believe that India would benefit from a cut in bureaucracy, increase in exports, additional reform measures, pick-up in government expenditures & consumer spending, superior demographics and improving penetration for banking and financial services. India could also benefit from manufacturing activity shifting away from China/South Korea if policies are attuned to the requirements of global manufacturers. As such, we have pencilled real growth of 4.3% over a rolling 10-year period.

How have we positioned our Managed Portfolios?

Since April 2019 (launch of portfolios), we have consistently maintained an underweight stance on Indian and US equities due to high valuation concerns. With the sharp correction in Indian equities, in line with major global equity markets over the last few weeks, we believe valuations have moderated significantly, although they still don’t appear to be in the ‘cheap/very attractive zone’ given the sharp run-up Indian equities saw between 2014 and 2017.

We have increased allocation to Indian equities in two ways: 1) change in valuation-driven target asset allocation weights across Indian large, mid and small cap segments and 2) rebalancing back to the target allocation. We have done this by utilizing extra cash and debt allocations. We have undertaken this action in order to respond prudently to recent market actions and is based on our valuation-driven asset allocation approach.

We continue to retain our underweight (albeit marginal) stance on Indian equities and marginal overweight positions in debt as compared to neutral or benchmark allocation. We continue to monitor the portfolios closely and stay focused on helping investors achieve their goals over the long term. As it has in the last few weeks, going ahead as well, our overweight position in cash (vis-à-vis neutral position) and debt should provide ammunition when attractive investment opportunities arise and protect ourselves on the downside.

We would like to conclude with a quote which appears to be apt in the current trying circumstances, Abraham Lincoln once wisely said:

“It is said an Eastern monarch once charged his wise men to invent him a sentence to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words `And this, too, shall pass away.' How much it expresses! How chastening in the hour of pride. How consoling in the depths of affliction!”

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