RBI focus on liquidity to soften govt bond yields

The Reserve Bank of India’s priority is liquidity management and it will continue to use OMO (open market operations) to infuse liquidity into the system.

The RBI has purchased government bonds worth Rs 67,000 crore from April 2012 to date, and it has signaled that it will buy more government bonds in order to keep system liquidity comfortable. Liquidity as measured by bids for repo in the LAF (liquidity adjustment facility) has been in a Rs 80,000 crore to Rs 90,000 crore deficit over the past three weeks, and with the RBI buying more bonds to infuse liquidity, this deficit is expected to come off down the line.

The RBI’s focus on liquidity will help government bond yields trend lower. The bond market was worried about absorbing a huge government bond supply that is averaging Rs 15,000 crore every week; ten-year benchmark bond yields reflected that concern and were trading at levels of 8.7 percent at the beginning of April. The RBI buying of bonds has helped ease supply fears and the ten-year benchmark bond, the 8.15 percent 2022 bond is trading at around 8.15 percent levels, down 55 basis points from their highs.

Government bond yields are likely to trend below 8 percent in the coming weeks as the market gets comfort from the presence of the RBI in the market. Bond yields will trend significantly below 8 percent if the market starts expecting repo rate cuts in its July policy review. The fact that the RBI refrained from cutting rates in today’s policy review will help markets to price in rate cut expectations in July, which is better than pricing in a rate cut that has already happened.

The RBI held policy rates of CRR (cash reserve ratio) and the repo rate steady in its policy review today. The markets were expecting a 25bps repo rate cut and the no change policy stance by the RBI has seen some rate cut positions being unwound. The Sensex and Nifty have fallen by over 1 percent while ten year bond yields have risen by eight basis points post policy.

The RBI held back rate cuts this policy citing inflation at levels of 7.55 percent, up from 6.9 percent seen in January 2012. The fact that the RBI had cut repo rates by 50 basis points in its April policy to address growth concerns of GDP and IIP, whose growth came in at 5.3 percent for the fourth quarter of 2011-12 and 0.1 percent in April 2012, respectively, played a part in RBI maintaining policy rates in its latest review.

The RBI’s infusion of liquidity through CRR cuts and bond purchases has made its monetary stance more accommodative and it did not have to cut rates to reinforce its stance of helping growth with price stability. The RBI has infused liquidity worth Rs 1,35,000 crore through government bond purchases since the beginning of calendar 2012 of which Rs 67,000 crore have been in the new fiscal (2012-13).

The RBI’s cut of 125 basis points in CRR since January 2012 infused Rs 80,000 crore into the system. The total liquidity infusion through government bond purchases plus CRR cuts in the first six months of 2012 is Rs 2,15,000 crore. The RBI has also been lending around Rs 80,000 crore to Rs 90,000 crore on a daily basis to the system through the LAF (Liquidity Adjustment Facility) window, adding on to the system liquidity infusion.

The increase in limit of export credit refinance of banks from 15 percent of outstanding export credit to 50 percent of outstanding export credit is likely to release Rs 30,000 crore into the system, which is equivalent to a 50 basis point CRR cut. RBI’s medium term CRR target is 3 percent and it will look to cut CRR when it believes that inflation is coming off and staying down.

Arjun Parthasarathy is the editor of www.investorsareidiots.com, a web site for investors.