The bond market is not expecting any repo rate actions by the RBI on the 1st of April 2014. Rate actions at this juncture is unwarranted is the belief in the market. However the market desperately needs clarity on liquidity. The market is still confused on what is the operational rate at present, the repo rate or the MSF (Marginal Standing Facility) rate. Repo rate the benchmark policy rate is at 8% while the MSF rate, which is the rate at which RBI lends funds to banks that are stuck for cash is at 9%.
RBI can afford to lend clarity on liquidity now as the Indian Rupee (INR) is trading at eight months highs against the USD. Recalling events of the past, RBI made liquidity costly for banks in the July-September 2013 period when the INR tanked to all time lows of Rs 68.80 against the USD. RBI curbed banks access to the LAF (Liquidity Adjustment Facility) window where it lent funds to banks at the repo rate. Banks access to LAF was restricted to 0.5% of their NDTL (Net Demand and Time Liabilities), from unrestricted access prior to the restriction.
RBI forced banks to borrow from the market or from the MSF window and it raised the MSF rate to 300bps over the repo rate. The normal spread is 100bps over the repo rate. This move by the RBI took up overnight rates by 300bps.
RBI since then has brought down the Repo-MSF spread to normal levels of 100bps as the INR stabilized. RBI is yet to remove the restrictions on banks access to LAF despite the fact that the INR has strengthened by 12% from lows seen in August 2013.
The market is short of funds and is forced to borrow from the RBI on a daily basis. Given restrictions on LAF, RBI is conducting term repo auctions i.e. repo auctions for 7 days, 14 days, 21 days and 28 days. The market is bidding for the term repo funds in the 8% to 9% range. The market is also forced to access the MSF window for funds at 9%.
The tight liquidity conditions have taken the markets borrowing from the RBI, under LAF, term repo and MSF to levels of Rs 1570 billion as of 21st March 2014. Liquidity will ease in April as banks release fiscal year end hoards of cash but given that government is unlikely to spend its cash surplus (government is running a cash surplus that is parked with the RBI) before July 2014 when the budget is presented by the new government, liquidity will stay tight in the system.
The government will also commence its first half of 2014-15 borrowing in April and as it borrows around Rs 450 billion to Rs 600 billion a month, the money will go out of the system and will not come back in the form of government spending.
Dr. Rajan will need to address the liquidity issue in his 1st April 2014 policy. What can he do to ease system liquidity? Reducing the CRR (Cash Reserve Ratio) rate is one way of easing liquidity. CRR is at 4% of NDTL and a reduction of 1% will release around Rs 800 billion into the system. Easing restrictions on LAF borrowing would make the repo rate the operational rate and banks will be able to borrow at 8% for fund requirements.
RBI may also consider buying USD to shore up its foreign exchange reserves. RBI buying USD injects liquidity into the system.
OMO (Open Market Operations) bond purchase auction is another way of adding liquidity into the system.
Easing of CRR and removing restrictions on LAF is the most seamless option for the RBI to add system liquidity. USD purchases is not warranted given that the INR is still down over 30% against the USD over the last three years. OMO bond purchase is back door deficit financing that is inflationary in nature.
