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Where has liquidity vanished?

Pranav Thakur

IT was another treacherous fortnight for bond traders, which saw yields firm up further behind high overnight rates and continued Government bond issuance at the long end.

In spite of the market displaying complete apathy for the long end, the Reserve Bank of India brought in another price-based auction for Rs. 4,000 crores in the seven-year tenor. This resulted in the long-end dropping another one to one-and-a-half rupees . Even after this huge drop, the issue was only partially subscribed.

The RBI had to devolve the bulk of the issue onto the PDs (who had to be paid a hefty underwriting commission for doing so) and onto itself. In the end, the central bank only pushed up yields by around 20 basis points in the seven-eight year tenor, witho ut actually placing much Government paper in the market.

The overnight rates ruled tight through the fortnight, touching a high of 30 per cent on the reporting Friday. RBI's newly designed LAF (Liquidity Adjustment Facility) took off on June 5. It only aided the tightening of overnight rates.

In the old regime, roughly Rs. 4,000 crores of refinance was available to the market at 9 per cent. Under the new LAF, however, both the amount as well as the rate have become flexible.

In a bid to keep the dollar-rupee quiet, the central bank may have decided to push up the overnight rate for the time being. Hence, it decided to satiate only a part of the market's hunger for funds by accepting roughly half of the total bids on a daily basis (about Rs. 2,500 crores on most days as opposed to bids of around Rs. 5,000 crores). This led to desperate borrowers bidding at higher rates every day which, in turn, saw the reverse repo cut-off shoot up from 9 to 10.85 per cent in a matter of day s.

To add to the market's woes, the central bank decided not to give any refinance on the last day of the reporting cycle. This must have led to a shortfall of products to the extent of at least a thousand crores, which caused the overnight rate to rise to 25-30 per cent.

I know of borrowers who were desperately looking for funds till late afternoon.

This brings us to the moot point of what has led to this acute liquidity crunch. The system's reliance on refinance has grown by around Rs. 7,500 crores in the last fortnight. Tier one refinance has grown by around Rs. 5,000 crores, add to it the Rs. 2,5 00 crores of liquidity injected by RBI on a daily basis through reverse repos. The average overnight lending by the banks is also sharply down by around Rs. 3,000 crores.

There does not seem to be a commensurate outflow from the system to explain such tightness. Only about Rs. 3,500 crores seems to have gone out of the system -- Rs. 2,500 crores on account of govy auctions and another Rs. 1,000 crores on account of a fall in the RBI's forex reserves (as of June 9). Credit does not seem to be growing at such a pace, as of now, to cause such tightness. Moreover, the big Government spending at the end of the last month should have also found its way into the mar ket by now.

One popular interpretation doing the rounds in the market is that the central bank is sucking out liquidity through sell-buy swaps, with some big lending nationalised banks on a Monday to Friday basis (to not show a fall in its reserves when it reports i ts figures every Friday). This is being done to keep overnight rates high, which would, in turn protect the rupee. If that is the case, then liquidity will ease off once the forex market stabilises. But if the tightness is on account of some genuine syst em outflows, we are in for trouble.

Last year, the mismatch between bank assets and liabilities was more than Rs. 40,000 crores. Given that April saw industrial production grow by 12 per cent, there is no reason for this trend to reverse.

The RBI would like to see the headline inflation number come down before it moved to cut CRR. Looking at the hefty growth in industrial production and the continued pressure on international crude prices, inflation also does not look like coming down in a hurry. July should be an easier month in terms of liquidity, thanks to some big Government securities maturing. But overall, the liquidity situation looks quite grim. Once credit starts picking up, it will only make matters worse.

The sentiment on the govys continues to be bad. Even the short-end has moved up quite significantly. Any liquidity easing will only help the short-end. Most of the traders are sitting light on the long end, so prices on their own will not fall any furthe r. But any new issuance in that tenor will again cause prices to fall quite sharply. AAA credit spreads have stayed in the 80-85 basis points range purely due to few corporate issuances. Once it picks up, even credit spreads will come under pressure.

It is best to stay away from the market till the outlook on liquidity clears. For compulsive buyers, the absolute long-end looks the safest.

(The author is Trader, Interest Rates, HSBC. The views expressed here are his own and not necessarily those of his employer.)