RBI Policy: Falling Short-Term Rates May Prompt Review Of Liquidity Conditions
The Reserve Bank of India sign is displayed inside central bank’s headquarters in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

RBI Policy: Falling Short-Term Rates May Prompt Review Of Liquidity Conditions

The Reserve Bank of India may have cause to review its ultra-easy liquidity policy when it meets this week, as short-term corporate and government borrowing rates have remained below its policy benchmark rates for an extended period.

Yields on commercial paper have traded not only below the policy repo rate, the rate at which the RBI lends overnight funds to banks, but also below the reverse repo rate at which banks park funds with the central bank.

According to data from CARE Ratings, the average liquidity surplus in the banking system rose further to Rs 5.31 lakh crore in November, compared to Rs 4.03 lakh crore last month and Rs 2.33 lakh crore in November 2019.

The excess liquidity is driving down the short-term government and corporate borrowing rates.

“The commercial paper rates have been falling clearly because of the excessive liquidity in the banking system. Higher capital inflows in November, owing to record foreign inflows, have further boosted liquidity,” said Rajeev Radhakrishnan, head of fixed income at SBI Mutual Fund.

If this (surplus liquidity situation) continues, it would lead to a persistent mispricing in the commercial paper market as the existing yields are becoming unsustainable for investors. Even the policy rates are losing relevance due to the abundant liquidity scenario. So, there needs to be an immediate intervention from the RBI.
Rajeev Radhakrishnan, Head - Fixed Income, SBI Mutual Fund

The 90-day weighted average commercial paper yields, as per data from the F-TRAC platform of the Clearing Corporation of India, fell steadily to 3.84% in November from 4.38% in October. This is below the RBI’s 4% repo rate and marginally above the reverse repo rate, which the market sees as the de facto policy rate in surplus liquidity times.

Moreover, a quarter of the 274 companies that tapped the commercial paper market for borrowing funds via short-term bonds, with maturity below or equal to 90 days, raised funds below the reverse repo rate of 3.35% in November.

Funds into short-term paper are flowing in from corporate treasuries and mutual funds, who cannot park money at the RBI’s reverse repo window. As such, they are willing to invest even below the floor rate set by the central bank.

In November, 23 companies borrowed funds via 90-day commercial paper issuances at lower than reverse repo rate, including the Export Import Bank of India, which issued a 90-day paper on Nov. 20 at 3.04%, and Kotak Mahindra Investments Ltd. that raised Rs 125 crore on Nov. 26 at 3.13%. On Nov. 27, NTPC raised Rs 2,000 crore via 91-day CPs at 2.97%..

Further, 67 companies that issued shorter tenor papers with maturity below 90 days, also borrowed at lower than reverse repo rate, including Berger Paints India Ltd, NLC India Ltd, and Reliance Industries Ltd.

The mutual funds do not have access to interbank rates, as they cannot park their liquidity with the RBI in the reverse repo market like banks can, they don’t have a choice but to keep on buying these short-term commercial papers. Because of this, the rates have compressed so much that investors are buying CPs even below the RBI’s reverse repo rate.
Parag Kothari, Associate Director, Trust Capital Services (India) Pvt Ltd.

To be sure, even short-term government borrowing rates have remained consistently below the repo and reverse repo rate.

At the last auction on Nov. 25, the 91-day treasury bill was sold at a yield of 2.92%, showed data from the RBI. The government, however, is borrowing more via longer-dated bonds in the second half of the year.

“Another reason for the falling short-term yields is the restricted supply of treasury bills (short-term paper, of up to one year maturity, issued by the government) in the system, compared to the first half of the year. Since the net supply is less, T-bill rates have also collapsed, causing a corresponding reduction in the overall money market rates,” said Radhakrishnan.

What Will RBI’s Stance Be?

The market is expecting the RBI to tighten liquidity in the upcoming monetary policy, and rein in the easy liquidity that was made available during the year, said Kothari. “The central bank should, at the least, mop up excess liquidity up to Rs 3 lakh crore through monetary interventions to stabilise the money markets.”

The RBI, in its December policy review, needs to either issue market stabilisation bonds or consider introducing standing deposit facility for liquidity management, said Radhakrishnan. “However, both these liquidity absorption measures would come at a fiscal cost to the government, for which the room may not be available due to the rising fiscal deficit because of the pandemic,” he added.

The market stabilisation scheme is a temporary intervention from the RBI, where it issues short-term securities to mop-up excess liquidity. It was introduced in 2002 to deal with a huge inflow of foreign capital.

The SDF is a yet-to-be-used facility which allows banks to park as much money as they want with RBI without getting collateral, and at a lower rate than the reverse repo. That rate is yet to be determined.

“Distortion in the short-term rate needs to be addressed as there is too much liquidity and too less demand for money,” said Soumyajit Niyogi, associate director credit and market research at India Ratings & Research.

While the crisis like environment (due to the pandemic) warranted for abundant liquidity and easy monetary condition, the large balance of payments situation has further added to liquidity, said Niyogi, adding that any withdrawal of liquidity will have to be carefully communicated so as to not push up long term interest rates.

The prevailing condition should not create irrational exuberance and addressing such phenomena should not create signal extraction problem, and therefore, pressure on long term yields. The RBI can address this by conducting long-term reverse repo or could prepone normalisation of CRR (cash reserve ratio) to 4% from 3% in a calibrated manner.
Soumyajit Niyogi, Associate Director, India Ratings & Research

While short-term rates have fallen, long-term rates, such as the 10-year benchmark government bond, continue to trade with a spread of 190 basis points over the repo rate.

Also read: Term Premia Debate: RBI’s Michael Patra Counters JR Varma’s View

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