The RBI would gradually withdraw the excess liquidity in the system and then reverse interest rates.
The current interest rates reflect the support needed for a pandemic-hit economy. At 4 percent and 3.35 percent, respectively, the RBI repo and reverse repo rates are at record low levels. What are the implications of such low interest rates?
-Real rates are negative. CPI inflation has been more than 6 percent in 2020, but for the last month (4.6 percent in December 2020) and SBI’s one-year deposit rate is less than 5 percent;
-Rates cannot remain so low forever. As a growing economy, we need capital; may not be currently, but after a year or so. Depositors need to be compensated.
In this backdrop, how has the RBI handled the situation? Very efficiently. It is not only the in-charge of interest rate decisions, but also the “merchant banker” for the Government’s borrowings from the market. It had the responsibility of ensuring that the huge Government borrowing to fund the bloated fiscal deficit goes through without disrupting the bond market.
What has the Budget done?
Of the announcements made in the budget, the ones relevant for interest rates were:
-Fiscal deficit estimate for 2020-21 at 9.5 percent of GDP: higher than revised estimates
-Fiscal deficit estimate for 2021-22 at 6.8 percent of GDP: higher than market expectations
-Additional borrowing of Rs 80,000 crore from the market this fiscal year: a negative for the market
-Gross borrowing from the market of Rs 12.06 lakh crore (INR 12.06 trillion) in 2021-22 against market expectation of Rs 10 to 11 trillion – another cause for worry
-Glide path for fiscal consolidation laid out: fiscal deficit to be brought down within 4.5 percent of GDP by 2025-26. However, this also is on the higher side: 4.5 percent is loose against the initial target of 2.5 percent. The Fiscal Responsibility and Budget Management Act is up for amendment.
Instead of putting additional tax burden on citizens (say, super-rich tax / wealth tax / COVID cess) the FM has allowed higher deficit and increased borrowings from the market. This effectively puts more money in the hands of citizens, which is a priority in this hour of stress. The stock market has given a big thumbs-up reaction, and this is a major reason.
In the secondary market for G-Secs, yield levels have moved up by 10 – 12 basis points in reaction to the higher-than-expected borrowing program. G-Secs are the first to react; other segments of the rates market and interest rates on the ground take cues from this.
Where are interest rates headed?
As mentioned earlier, there has to be a reversal of the emergency-level low interest rates. It is a matter of time; depending on the level of economic recovery, the RBI would gradually withdraw the excess liquidity in the system and then reverse interest rates. The saving grace is that even after some reversal in rates, the RBI can support growth. That is, rates will be low enough to incentivise people to borrow, but be remunerative for depositors, too.
It’s over to the RBI now. The Policy Review is scheduled for Friday (February 5). The “language,” i.e., guidance on interest rates has to be carefully drafted to signal that there may not be further rate cuts (the high fiscal deficit does not give scope to the RBI for policy easing); yet, at the same time, it must not to upset the apple cart. It will have to sail through the Government borrowing program.
Conclusion
As an investor in bond funds, it is advisable to invest in debt schemes that have a relatively shorter portfolio maturity or a portfolio maturity that broadly matches your investment horizon. This will reduce the impact on your debt investments, if and when interest rates move, over the next year or so.
Source: https://www.moneycontrol.com/news/business/personal-finance/budget-2021-what-it-means-for-interest-rates-and-debt-fund-investors-6435421.html