“Financial markets are vital to the functioning of every modern economy. From a macroeconomic policy perspective, besides the crucial role of price discovery for a host of financial assets, they enable risk and maturity transformations, incentivise the efficient allocation of resources, generate returns for capital and bring borrowers and lenders, and savers and investors together. They also nurture a synaptic continuum across various market segments that deal in various financial assets. Overarchingly, the information content in financial markets is priceless for regulators like the Reserve Bank.” Michael Patra, DG, RBI (November 2022).
Words of wisdom indeed. The role of monetary policy in enabling better policy transmission to financial markets has always been the endeavor of any central bank and RBI is no exception. While, it has been observed that the transmission from a rate change is instantaneous in money market, it is not so in the bank lending and the G-sec market given the market idiosyncrasies. Also, the transmission is supposed to have a positive relationship.
With liquidity in the system currently in a deficit mode, the question that is posed here underpins whether such liquidity tightening impulse is fully and adequately reflected in the money market rates? The endeavour is to find out whether over a sufficiently long period of RBI rate cycle, the resultant transmission in the money market , bank credit market and G-sec market moves in the same direction: i.e. a rate hike / cut begets a tighter / lower money market rates.
The starting point of analysis is the spread between AAA corporate bond and 10-year risk free G-sec rates, which was around 120 bps during March/April’2020 but has declined significantly since then. This trend has continued even as the rate cycle changed direction since April’2022 and is now even significantly less than half of the average spread at pre pandemic level i.e. in FY20. This indicates that risk pricing of the paper which was lower during low demand and high liquidity has not moved up commensurately even though the credit demand has picked up and liquidity dried up, reflecting inadequate risk premium. Does this reflect a new found peculiarity of asymmetric transmission from monetary policy to rate transmission in Indian money markets, G-sec market and even bank credit market? This hypothesis of rate transmission has been tested by using an autoregressive distributed lag model (ARDL) for the 65 month ended August 2023. The data series thus constitutes both periods of rate hikes and rate cuts by RBI.
The results are as follows:
- A 1% increase in repo rate has resulted into only 2 to 3 bps increase in 10 year AAA corporate bond spread, 3 to 4 bps increase in 5 year AAA corporate bond spread, but there has been around 31 bps decrease in spread of 3 year AAA corporate bond, signifying that 3 year AAA corporate bonds are not priced with adequate risk premium and they could have been at least be priced at 26-43 bp higher rate. Could this be a result of better bargaining power of corporates or exuberant risk pricing? The jury is out though and an area of further research.
- A 1% increase in repo rate increases CP weighted yield by 120 bp increase for up to 31 day tenor, by 147 basis points in 31 days to 91 days, 178 basis points in 92 days to 180 days and surprisingly lower at 151% in 181 days to 365 days tenor. Further estimates suggest that 180-365 days CPs are priced exuberantly and are under priced by up to 90 bps.
- As far as bank credit is concerned, market sources pointing short tenor working capital loans of less than one year are given even with finer rates in the range of 7-7.5% or even less. It is to be noted that 10-Yr G Sec is currently trading around 7.18%, while 91 Day T Bill at around 6.85% and 182 Day T Bill at around 7.04%. The pricing for a corporate paper should generally be higher by at least 50-100 bps, to cover the risk premium, over Government paper depending upon rating, tenor etc.
- Overall, estimates reveal that at an annualized rate, some borrowers might have been able to save up to Rs 5000 crores because of lower CP rates largesse even if inadvertently ingrained in broader markets psychology. This has resulted in better financial service ratio. For example, the interest coverage ratio of listed entities, ex BFSI, improved by 60 bps in Q1FY24 as compared to Q1FY23 reflecting lower input cost including finance cost.
Clearly, monetary policy has asymmetric transmission in Indian financial markets. Future conduct of monetary policy may look into this aspect , but the end result could be monetary policy signaling is now dictated more by fuzzy market peculiarities!
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