Will rates continue to fall in the country?

Will rates continue to fall in the country?

Last updated: 10 Jul, 2020 | 02:44 pm

Will rates continue to fall in the country?

The function of central banks

  • Central banks of every country (such as RBI in India) use adjustments in borrowing and lending rates to control the money supply in the economy.
  • Lower rates are used to increase the money available which helps spur up inflation and growth in the economy.
  • Higher rates are used to control overheating of inflation in the economy which could lead to spiralling prices and be detrimental to the economy
  • This delicate balancing of rates by the central bank is used to achieve sustainable growth in the economy.

What’s happening in the current environment

  • Central Banks around the world are cutting interest rates to promote growth and liquidity. 
  • RBI has cut repo rate by 115 bps from 5.15% to 4% since January 2020.
  • While the RBI has cut rates, increasing the availability of money in the economy, the effects of these cuts haven’t been felt to a large extent.
  • Despite the moves by RBI, banks have not been extending credit to the cash strapped economy. Bank credit (non-food) is down ₹1.6 Lk Cr in this Financial year alone!  This includes loans, cash credits (against pledged assets) and overdrafts extended to companies.
  • This is because of the heightened credit risk in lending currently caused by a widespread disruption in the economy. Banks have preferred to park their money in safer Government securities instead- investments by banks in government securities is up over ₹4 Lk Cr this FY (Since Apr 1).

So will the RBI continue to cut rates

  • Clearly the RBI has a problem of transmission. Rate cuts are having a limited impact in giving business and the economy a boost, since banks are unwilling to assume the credit risk in this choppy environment.
  • The government has resorted to a much needed Fiscal stimulus by schemes that directly put money in the hands of certain targeted sectors- Although much more is expected.
  • RBI is also implementing operation twists and open market operations to reduce the long term yields and speed up the effectiveness of transmission of rate cuts.
  • While there is pressure on the RBI to keep rates low (Dovish in monetary policy parlance), the RBI will remain constrained to cut rates meaningfully given the factors above and possible impact on currency (lower interest rates lead to outflows from the country).
  • In the short term (3-6 months), we don’t expect the RBI to cut rates by more than 50-75 bps.

So, what is expected in the long term?

  • Monetary policy changes and fiscal measures are good measures to promote growth in the short term given the devastating impact of shutdowns in the economy. 
  • However, in the long term, fundamental factors of the economy guide real growth and sustainability.
  • As expected, the government’s revenue decreased significantly during the lockdown but bounced back to 85-90% of pre-COVID levels in May.
  • The economy is saddled currently with high unemployment (even in pre COVID times) and low demand (Private consumption is at multi-year lows), businesses are struggling.
  • With high government expenditure, low revenue and a depreciating currency, India’s fiscal deficit is continuously increasing (difference between total income and total expenditure). 
  • The fiscal deficit reached 4.66 lakh crore in the first 2 months of FY21 (27% higher than what it was in the same period in FY20). As per ICRA rating agency, the deficit is expected to expand to Rs 13 lakh crore in this fiscal. 
  • As the lockdown eases, day to day business activities will resume. Demand will slowly start pushing back. This is still far away but we should see some impact in the coming quarters.
  • Fiscal deficit has a strong impact on inflation. As fiscal deficit increases, inflation picks up (to fund the deficit). 
  • Given the fragile state of India’s economy and currency, we can not afford to let the deficit run too far ahead.

The current state points to a bottoming of the current interest rate cycle and rates should increase in the long term (1-3 years) 

This is exactly what happened post-2008 global recession. During the crisis, RBI reduced interest from 9% to 4.75% in a span of 1 year. Then as inflation picked up, rates started increasing.

Current Risks in Fixed Income Market:

India’s sovereign rating downgrade to Junk: India’s current rating is currently just one notch above a junk rating. If the rating downgrades to junk, a majority of foreign investors will sell Indian bonds as many of them are mandated by their IPS to not invest in any bond within the junk category. This will cause a temporary sharp rise in yields. However, domestic investors would still continue to hold and buy those bonds. Therefore the yields should normalize after some time.

A high number of defaults and rating downgrades: As soon as moratorium gets lifted, lenders will see a sharp rise in NPA’s. The current numbers are not a true reflection of the hidden risk in the system. As those numbers increase, ratings of many companies are expected to go down and many are even expected to default. The credit risk in the system is very serious.

Liquidity risk of low-grade bonds: As risk has increased, investors are flocking to safety. Large scale selling in lower-rated bonds (anything less than AAA) has caused the prices to decrease sharply. Credit Risk funds in India saw a 50% outflow in the last 3 months. With extremely low demand for lower grade bonds, investors are unable to successfully liquidate these bonds. Liquidity was the primary reason why Franklin had to shut down 6 of their debt schemes.

High volatility in bond yields: The yields have been extremely volatile. This volatility makes short term entry and exit from bonds extremely difficult.

INDmoney Recommendation:

The credit risk, interest risk and liquidity risk are extremely serious in the system. It is very important to understand them before making any decision. Invest only high-quality AAA-rated bonds as they have the least risk. In fixed income securities, high risk does not mean higher returns.

There is a significant tax advantage in holding a debt fund for more than 3 years.For a more than 3-year investment horizon, an investor should prefer short duration (duration < 3) fixed income instruments over long duration. Short duration funds might not give you that extra alpha in the short term (3-6 months), but they are highly likely to outperform long duration funds in the long term. Shorter duration funds are also less sensitive to volatility in interest rates as compared to long duration funds.

Have more questions on the issue? Click on the Ask Advisor button to connect with your family wealth office to help you understand more about the current risk in the system and help you manage your portfolio.