RBI cut SLR (Statutory Liquidity Ratio) of banks by 50bps from 23% of NDTL (Net Demand and Time Liabilities) to 22.5% of NDTL in its bi monthly policy on the 3rd of June 2014. Apart from this structural policy move, the other policy changes were largely operational in nature.
RBI reduced liquidity provided under export credit refinance from 50% of eligible export credit outstanding to 32%. The central bank will conduct term repos for 0.25% of NDTL, which is around Rs 200 billion to compensate for the export credit refinance cut.
The SLR cut is largely to enable banks to provide more credit to the economy and will free up around Rs 350 billion of liquidity. Bond markets usually do not like SLR cuts as it believes demand for government bonds will come off as banks require to buy less of government bonds. The government is the largest supplier of bonds in the economy given that it finances around 90% of its fiscal deficit through market borrowings.
The bond market has not reacted too negatively to the SLR cut with bond yields largely remaining unchanged pre to post policy. The benchmark ten year bond the 8.83% 2023 bond is trading at 8.66% levels while the new on the run 8.60% 2028 bond is trading at 8.58% levels post policy.
One reason for bond yields to stay clam despite a SLR cut is that it could be a signal that the government is fine with allowing banks to buy less of bonds as it looks to consolidate the fiscal deficit. The market was worried that borrowings could rise in the July budget if the government embraces a fiscal deficit of 4.5% of GDP. The earlier projection was 4.1% of GDP and with higher fiscal deficit, government borrowing could rise by around Rs 600 billion.
The RBI too gave a signal to the markets that further rate hikes are not warranted given the core CPI (Consumer Price Index) has moderated over the last seven months and given weak economy, is unlikely to see uptick going forward. RBI also believes that the FM, Arun Jaitley will follow prudent policies on subsidies and administered prices.
CPI is expected to fall from current levels of 8.59% in the coming months due to base effect. RBI has factored in this base effect in its projections for CPI, which is expected to be around 8% by end March 2015 and 6% by end March 2016.
The central bank is open to lowering the repo rate if the CPI falls faster than expected.
Liquidity has eased in the system on the back of banks releasing fiscal year end hoards and on the back of government spending its surplus. Demand for funds from the RBI has come off by over Rs 1300 billion since end March. RBI will want to keep liquidity at deficit levels of around 1% of NDTL, which is Rs 700 billion. It will conduct term repos and term reverse repos to keep liquidity at levels that it feels comfortable.
On the whole the policy is more positive than negative for bond markets and bond yields should stay steady at current levels with direction being provided by government bond supply and budget.