Apart from 50 bps rate cut, RBI made few more changes to monetary policy. All of that will lead to multiple benefits such as improvement in liquidity situation, lower interest rates for both Govt. and retail segments, lower SLR for banks and increase in the demand for Rupee in international financial markets. Let us look at them in detail.
Foreign money in Govt. bonds
Foreign institutional players (FPI) have already exhausted their limits in holding the Govt. bonds indicating there was unmet demand. As RBI increased those limits (Link: http://www.dnaindia.com/money/report-allowing-higher-fpi-in-g-sec-cross-currency-trade-positive-steps-2130183), more foreign money will flow into Govt. securities in the coming months. Deposit rates are close to zero in many developed economies so it is natural for the fixed investment funds there to find way into India. But it was only restricted by the policy set by our central bank, which it revised now and has also committed to review or increase this limit every six months in the future. As the demand for Govt. securities increase, bond yields reduce so capital cost for Govt. will decrease marginally. Any savings will help. It also leads to reducing SLR (Statutory Liquidity Ratio) which is mandatory investment imposed on local banks, currently set at 21.5%, which will come down gradually. At least by 25 bps or so every six months in the near future. This will release huge amount of funds into banking system which it can lend freely to retail segment at slightly higher rates. That helps banks to improve profitability. As this freed up capital chases the same consumer base in India, competition among banks will intensify and the interest rates reduce. Banks profits will not come down as the lending rates to retail will still be higher even after reducing the rates (at 8% to 9%) than Govt. bond yields (less than 8%).
Rupee bonds in foreign currency
IFC toyed with this idea last year and it was fully subscribed. Encouraged by the enthusiasm, RBI is allowing more corporate to issue Rupee denominated bonds in foreign markets. Indian companies can borrow and settle in Rupee terms. They do not have to worry about forex fluctuations as that risk or reward wil be transferred to hedging companies. The companies which borrowed in Dollar terms in the past when Rupee was trading at 50 a dollar are in trouble in paying back their debt as they need 65 Rupees to get a Dollar now. With Rupee denominated bonds, Indian companies will not suffer the same risk as settlement is in Rupee terms. Idle money in the foreign markets will get into these bonds and hedging Rupee against other currencies will become a big business too. It helps coprporate to get funds at lower rate which is a feature of the developed market. The benefit for Indian consumer is, rush to borrow from banking system in India from the corporate will reduce. That helps interest rates to reduce.
How rates reduce?
Money in the banking system has three kinds of borrowers - Govt., corporate and the retail consumers. As the borrowing demand from Govt. and Corporate reduces due to policy changes in bond market, banks will be left with surplus funds (higher liquidity) and dependency on retail segment will increase. As all the banks compete for the same customer segment, they will drive down the rates to attract or retain their market share.
Rupee to become more stable
Interest rate coming down further next year is good news for us, the consumers. There is also another benefit. Foreign money coming into Govt. bonds will increase the demand for Rupee. Similarly Rupee denominated bonds too will see the conversion of foreign currency into Rupee. This broadens the holding base for Rupee in foreign markets. It will have many takers in the developed world, in which there is no demand to mention now. While I do not expect this to make Rupee gain against Dollar significantly, at least the downside will be protected. And volatility reduces as Rupee will have many takers in the international capital market. Is this a way for Rupee to get into Top 10 currencies of this world? Probably so, but Rupee has to become fully convertible which will take few years to reach there.
Summary
Essence of this story is, there will be more foreign debt, lower rates and a stronger currency in the times to come. These are clear signs of an economy transforming into a more global, mature economy. We may not beat the toppers anytime soon. But on PPP (Purchasing Power Parity) terms, we would have reduced the gap by a wide margin in the coming decade. Hopefully this translates India into a better society too.
Foreign money in Govt. bonds
Foreign institutional players (FPI) have already exhausted their limits in holding the Govt. bonds indicating there was unmet demand. As RBI increased those limits (Link: http://www.dnaindia.com/money/report-allowing-higher-fpi-in-g-sec-cross-currency-trade-positive-steps-2130183), more foreign money will flow into Govt. securities in the coming months. Deposit rates are close to zero in many developed economies so it is natural for the fixed investment funds there to find way into India. But it was only restricted by the policy set by our central bank, which it revised now and has also committed to review or increase this limit every six months in the future. As the demand for Govt. securities increase, bond yields reduce so capital cost for Govt. will decrease marginally. Any savings will help. It also leads to reducing SLR (Statutory Liquidity Ratio) which is mandatory investment imposed on local banks, currently set at 21.5%, which will come down gradually. At least by 25 bps or so every six months in the near future. This will release huge amount of funds into banking system which it can lend freely to retail segment at slightly higher rates. That helps banks to improve profitability. As this freed up capital chases the same consumer base in India, competition among banks will intensify and the interest rates reduce. Banks profits will not come down as the lending rates to retail will still be higher even after reducing the rates (at 8% to 9%) than Govt. bond yields (less than 8%).
Rupee bonds in foreign currency
IFC toyed with this idea last year and it was fully subscribed. Encouraged by the enthusiasm, RBI is allowing more corporate to issue Rupee denominated bonds in foreign markets. Indian companies can borrow and settle in Rupee terms. They do not have to worry about forex fluctuations as that risk or reward wil be transferred to hedging companies. The companies which borrowed in Dollar terms in the past when Rupee was trading at 50 a dollar are in trouble in paying back their debt as they need 65 Rupees to get a Dollar now. With Rupee denominated bonds, Indian companies will not suffer the same risk as settlement is in Rupee terms. Idle money in the foreign markets will get into these bonds and hedging Rupee against other currencies will become a big business too. It helps coprporate to get funds at lower rate which is a feature of the developed market. The benefit for Indian consumer is, rush to borrow from banking system in India from the corporate will reduce. That helps interest rates to reduce.
How rates reduce?
Money in the banking system has three kinds of borrowers - Govt., corporate and the retail consumers. As the borrowing demand from Govt. and Corporate reduces due to policy changes in bond market, banks will be left with surplus funds (higher liquidity) and dependency on retail segment will increase. As all the banks compete for the same customer segment, they will drive down the rates to attract or retain their market share.
Rupee to become more stable
Interest rate coming down further next year is good news for us, the consumers. There is also another benefit. Foreign money coming into Govt. bonds will increase the demand for Rupee. Similarly Rupee denominated bonds too will see the conversion of foreign currency into Rupee. This broadens the holding base for Rupee in foreign markets. It will have many takers in the developed world, in which there is no demand to mention now. While I do not expect this to make Rupee gain against Dollar significantly, at least the downside will be protected. And volatility reduces as Rupee will have many takers in the international capital market. Is this a way for Rupee to get into Top 10 currencies of this world? Probably so, but Rupee has to become fully convertible which will take few years to reach there.
Summary
Essence of this story is, there will be more foreign debt, lower rates and a stronger currency in the times to come. These are clear signs of an economy transforming into a more global, mature economy. We may not beat the toppers anytime soon. But on PPP (Purchasing Power Parity) terms, we would have reduced the gap by a wide margin in the coming decade. Hopefully this translates India into a better society too.
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