RBI has adopted the Dr. Urjit Patel committee report on strengthening the monetary policy framework recommendation and is progressively moving away from the LAF (Liquidity Adjustment Facility) regime, which provided guaranteed access to funds at the overnight repo rate.
Banks access to repo in the LAF is lowered from 0.5% of NDTL (Net Demand and Time Liabilities) to 0.25% of NDTL, which in absolute terms is down form Rs 400 billion to Rs 200 billion. RBI will correspondingly increase amounts lent under term repo to 0.75% of NDTL from 0.5% of NDTL or Rs 600 billion from Rs 400 billion.
Term Repos
What are term repos? Term repos are money market instruments where banks borrow from the RBI or from the market for a period of more than one day. Term repo is collateralized i.e. banks have to provide securities to the lender as collateral. RBI has started conducting term repos since October 2014 after it restricted banks borrowing from the LAF (Liquidity Adjustment Facility) at 1% of NDTL (Net demand and Time Liabilities).
In RBI’s auctions of 7 days and 14 days term repos, the bids for the repo came in at between repo rate of 8% and the MSF (Marginal Standing Facility) rate of 9%. RBI had allowed banks to borrow up to 0.75% of NDTL in term repo auctions. Hence term repos will always see bids between repo rates, where banks borrow overnight funds and MSF rate where banks borrow emergency funds.
A vibrant money market curve cannot really develop when the repo rate and MSF corridor is in existence. Term repo can make banks pay higher rates than the repo rate but with MSF lending in existence, a true market rate will not develop.
At a time when liquidity is in plenty, the market will lend funds to the RBI at reverse repo rate, which is 100bps below the repo rate. In this scenario, term repo will rule between the reverse repo and repo rate.
Ideally the OIS (Overnight Index Swaps) curve should be the forward money market yield curve as the OIS is benchmarked to call money rates. However given that call money rates rules between the repo and MSF rate, the OIS curve is more of a speculative yield curve that reflects market expectations of future rate hikes or rate cuts rather than market expectations of liquidity.
RBI moving to term repo to develop a money market yield curve can work only when the MSF is taken out of the equation or MSF rate is not fixed but determined by the market.
Liquid funds will be beneficiaries of the term repo market as they can lend at rates higher than repo rates but the benefit will be restricted to a maximum of 100bps (which is substantial for a liquid fund), as they will always be lending at or below the MSF rate. Money market securities such as treasury bills, certificate of deposits and commercial papers could see markets pricing them at yields over term repo rates rather than the repo rate and this will also benefit liquid funds.
