Going into the pandemic, monetary policy in India was already accommodative. The RBI had reduced the policy repo rate by 135bps in the calendar year 2019. And the money markets were also in a surplus liquidity situation. But through the course of the pandemic, three things changed: firstly, the repo rate was reduced by another 115bps to 4%. Second, the spread between the repo rate and the reverse repo rate was widened to 65bps from 25bps before the pandemic. And thirdly, the surplus liquidity in the system expanded even further.
As a result of this, money market interests were far lower than what they would be under ‘normal circumstances.’ Under normal circumstances, the repo rate is the rate around which money market rates hover. The inter-bank call rate is benchmarked against the repo rate as a tool for measuring the effectiveness of RBI’s liquidity management. But a confluence of the factors discussed above meant that money market interest rates were not just below the repo rate they were well below even the reverse repo rate. On several occasions, money market rates were 100bps below the repo rate!
This was until now. Last few weeks, money market rates have risen sharply and there some semblance of normalcy has started to return. Thus, the interbank call rate which has remained well below the reverse repo rate since October last year is now at the repo rate. Similarly, the Tri-party repo rate which has remained below the reverse repo rate since March last year is now above the reverse repo rate. This has happened because these money market rates have increased 25-30bps in the past few weeks.
Even higher up the yield curve, rates have risen in recent weeks. The yield on the 3mth sovereign bond has increased by almost 45bps since early October and is the highest since April last year. Similarly, the 1yr sovereign bond yield has increased by almost 50bps since August. At 4.1%, the 1yr bond yield is now above the repo rate after being below it pretty much throughout since April last year. The yields have increased at the long end of the curve also, but by a lesser magnitude – the 10yr yield has increased by ~25bps in the last few weeks.
The bottom line is that while the RBI has not signalled any change in monetary policy stance (liquidity surplus remains large), the markets have adjusted and prepared for a return to more normal times. The money market rates are now anchored close to the reverse repo rate, the de-facto monetary policy rate currently. Short-term government bond yields are now in sync with the pre-pandemic levels, given the policy rate.
However, the adjustment is still incomplete. The next stage in the return to normalcy will require money market rates to be anchored to the repo rate rather than the reverse repo rate. And this will imply a 50-60bps rise in money market rates from the current levels. But this will require the RBI to either take away the liquidity punchbowl or sterilise the excess liquidity. Irrespective, the interest rate cycle is now on an upswing.