RBI had no option but to kill the debt fund

The Reserve Bank of India(RBI) is doing everything that it can do to stop the rupee from falling against the dollar. Yesterday it announced further measures on that front.

Each bank will now be allowed to borrow only upto 0.5% of its deposits from the RBI at the repo rate. Repo rate is the interest rate at which RBI lends to banks in the short term and it currently stands at 7.25%.

Sometime back the RBI had put an overall limit of Rs 75,000 crore, on the amount of money that banks could borrow from it, at the repo rate. This facility of banks borrowing from the RBI at the repo rate is referred to as the liquidity adjustment facility.

The limit of Rs 75,000 crore worked out to around 1% of total deposits of all banks. Now the borrowing limit has been set at an individual bank level. And each bank cannot borrow more than 0.5% of its deposits from the RBI at the repo rate. This move by the RBI is expected bring down the total quantum of funds available to all banks to Rs 37,000 crore, reports The Economic Times.

In another move the RBI tweaked the amount of money that banks need to maintain as a cash reserve ratio(CRR) on a daily basis. Banks currently need to maintain a CRR of 4% i.e. for every Rs 100 of deposits that the banks have, Rs 4 needs to set aside with the RBI.

Reuters

Reuters

Currently the banks need to maintain an average CRR of 4% over a reporting fortnight. On a daily basis this number may vary and can even dip under 4% on some days. So the banks need not maintain a CRR of Rs 4 with the RBI for every Rs 100 of deposits they have, on every day.

They are allowed to maintain a CRR of as low as Rs 2.80 (i.e. 70% of 4%) for every Rs 100 of deposits they have. Of course, this means that on other days, the banks will have to maintain a higher CRR, so as to average 4% over the reporting fortnight.

This gives the banks some amount of flexibility. Money put aside to maintain the CRR does not earn any interest. Hence, if on any given day if the bank is short of funds, it can always run down its CRR instead of borrowing money.

But the RBI has now taken away that flexibility. Effective from July 27, 2013, banks will be required to maintain a minimum daily CRR balance of 99 per cent of the requirement. This means that on any given day the banks need to maintain a CRR of Rs 3.96 (99% of 4%) for every Rs 100 of deposits they have. This number could have earlier fallen to Rs 2.80 for every Rs 100 of deposits. The Economic Times reports that this move is expected to suck out Rs 90,000 crore from the financial system.

With so much money being sucked out of the financial system the idea is to make rupee scarce and hence help increase its value against the dollar. As I write this the rupee is worth 59.24 to a dollar. It had closed at 59.76 to a dollar yesterday. So RBI's moves have had some impact in the short term, or the chances are that the rupee might have crossed 60 to a dollar again today.

But there are side effects to this as well. Banks can now borrow only a limited amount of money from the RBI under the liquidity adjustment facility at the repo rate of 7.25%. If they have to borrow money beyond that they need to borrow it at the marginal standing facility rate which is at 10.25%. This is three hundred basis points(one basis point is equal to one hundredth of a percentage) higher than the repo rate at 10.25%. Given that, the banks can borrow only a limited amount of money from the RBI at the repo rate. Hence, the marginal standing facility rate has effectively become the repo rate.

As Pratip Chaudhuri, chairman of State Bank of India told Business Standard, "Effectively, the repo rate becomes the marginal standing facility rate, and we have to adjust to this new rate regime. The steps show the central bank wants to stabilise the rupee."

All this suggests an environment of "tight liquidity" in the Indian financial system. What this also means is that instead of borrowing from the RBI at a significantly higher 10.25%, the banks may sell out on the government bonds they have invested in, whenever they need hard cash.

When many banks and financial institutions sell bonds at the same time, bond prices fall. When bond prices fall, the return or yield, for those who bought the bonds at lower prices, goes up. This is because the amount of interest that is paid on these bonds by the government continues to be the same.

And that is precisely what happened today. The return on the 10 year Indian government bond has risen by a whopping 33 basis points to 8.5%. Returns on other bonds have also jumped.

Debt mutual funds which invest in various kinds of bonds have been severely impacted by the recent moves of the RBI. Since bond prices have fallen, debt mutual funds which invest in these bonds have faced significant losses.

In fact, the data for the kind of losses that debt mutual funds will face today, will only become available by late evening.

But their performance has been disastrous over the last one month. And things should be no different today.

In fact, many debt funds have lost as much as 5% over the last one month. And these are funds which give investors a return of 8-10% over a period of one year. So RBI has effectively killed the debt fund investors in India.

But then there was nothing else that it could really do. The RBI has been trying to manage one side of the rupee dollar equation. It has been trying to make rupee scarce by sucking it out of the financial system.

The other thing that it could possibly do is to sell dollars and buy rupees. This will lead to there being enough dollars in the market and thus the rupee will not lose value against the dollar. The trouble is that the RBI has only so many dollars and it cannot create them out of thin air (which it can do with rupees). As the following graph tells us very clearly, India does not have enough foreign exchange reserves in comparison to its imports.

import-cover_380

India does not have enough foreign exchange reserves in comparison to its imports.

The ratio of foreign exchange reserves divided by imports is a little over six. What this means is that India's total foreign exchange reserves as of now are good enough to pay for imports of around a little over six months. This is a precarious situation to be in and was only last seen in the 1990s, as is clear from the graph.

The government may be clamping down on gold imports but there are other imports it really doesn't have much control on. "The commodity intensity of imports is high," write analysts of Nomura Financial Advisory and Securities in a report titled India: Turbulent Times Ahead. This is because India imports a lot of coal, oil, gas, fertilizer and edible oil. And there is no way that the government can clamp down on the import of these commodities, which are an everyday necessity. Given this, India will continue to need a lot of dollars to import these commodities.

Hence, RBI is not in a situation to sell dollars to control the value of the rupee. So, it has had to resort to taking steps that make the rupee scarce in the financial system.

The trouble is that this has severe negative repercussions on other fronts. Debt fund investors are now reeling under heavy losses. Also, the return on the 10 year bonds has gone up. This means that other borrowers will have to pay higher interest on their loans. Lending to the government is deemed to be the safest form of lending. Given this, returns on other loans need to be higher than the return on lending to the government, to compensate for the greater amount of risk. And this means higher interest rates.

The finance minister P Chidambaram has been calling for lower interest rates to revive economic growth. But he is not going to get them any time soon. The mess is getting messier.

Vivek Kaul is a writer. He tweets @kaul_vivek


Published Date: Jul 24, 2013 02:50 pm | Updated Date: Dec 20, 2014 09:15 pm


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