Liquidity conundrum: Govt, Reserve Bank of India have done their bit, but it isn't easy to bell the cat

The financial markets are in a state of flux. Liquidity is a challenge as there are fewer funds in the market. This can be gauged by the fact that the net repo outstanding in the system if above Rs 1.5 lakh crore, which in effect is the borrowings from the Reserve Bank of India (RBI). With the RBI periodically selling dollars in the market, rupee funds are being taken out from the market. To an extent the RBI compensated the banks with proactive OMO to infuse funds. At the same time the mutual funds industry is grappling with the issue of re-balancing their portfolios and meeting redemption pressures. Interest rates have started moving up and the 10 years GSec rate is above 8 percent and till sometime back was between 8.10-8.15 percent. This means that there will be a major mark-to-market hit for banks as they revalue their portfolio on 30 September. It is still uncertain if banks have made adequate provisions for their NPA recognition for this quarter and a significant MTM hit would be a dual puzzle for them. This is why the market was keen to understand what the RBI and the government were going to do to stabilize markets. Both the RBI and the government have announced measures to improve the liquidity in the system and above all improve sentiment which is more critical today. The conjecture really is whether this will work.

The RBI has provided additional elbow room to banks in terms of managing their SLR portfolio by making allowances in reckoning their Liquidity coverage ratio (LCR). The LCR is something which banks have to maintain in relation to the monthly cash flows that they reckon.

The liquid assets that they have to maintain against these commitments would move towards 100 percent in 2019. The liquid assets have been defined as being carved partly from the SLR. [caption id=“attachment_5129811” align=“alignleft” width=“380”]  Representational image. Reuters[/caption] After taking into account the 2 percent MSF (MSF is the additional borrowing which is permitted by RBI beyond the one percent repo of NDTL at a higher interest rate of 50 bps above repo rate) banks were allowed to use 13 percent of the 19.5 percent SLR for this calculation. Now the 13 percent limit has been enhanced to 15 percent, which means that theoretically banks can sell off 2 percent of the total NDTL kept as securities and use it for lending purposes. This could be in the region of around Rs 2.5 lakh crore if everything was sold in the market.  Representational image. Reuters. However, while this will make things easy for banks at the individual level, if all banks were to divest their holding of excess SLR holding, there would be no buyers in the market. It is, therefore, not surprising that while this announcement did assuage the market, it was only in a limited manner. Banks are presently holding on to excess SLR of around 8-9 percent more on account of GSecs being safe investments given the risk in commercial lending, especially to corporate. The other important announcement came from the government. The borrowing programme for the second half of the year from the central government would be lower at Rs 2.47 lakh crore, and hence for the entire year would be lower by Rs 70,000 crore where the budgeted gross borrowing programme was Rs 6.05 lakh crore. It has also been reiterated that the fiscal deficit target of 3.3 percent will be achieved and there was no chance of a slippage. On the face of it, this measure sends the right signal as it gives the impression that the government is borrowing less in the market. However, the government has also stated that the net borrowing programme would be the same at Rs 3.9 lakh crore. Therefore, while gross borrowing will be lower, net borrowings remains the same. This puzzle is not hard to solve as the Budget had spoken of buyback of around Rs 70,000 crore of securities. This is normally done to buyback either illiquid or expensive paper.  Therefore, the buybacks would be reduced to compensate for the lower borrowings.  Hence, the lower level of gross borrowing for the year should not be interpreted as the government earning more from revenue or spending less as the Budget had spoken of raising more funds and buying back the same amount from banks. There was also a step taken earlier to increase the returns on small savings which could be adding to the flow of funds for the government. This would provide a buffer for the possible slippage in the fiscal deficit. The assertion that the fiscal deficit target would be achieved is hence also backed by this move. Putting both these measures together it can be seen that the market would still be watchful and this sentiment would work its way through the next few trading sessions till the credit policy is announced. But liquidity per se will not be affected in the immediate run due to the borrowing programme announcement though the LCR relaxation will at the margin help banks in the release of resources.

The credit policy will hold the ultimate clue to both liquidity and direction of rates. The repo rate will almost certainly be raised which will keep yields steady in the upward direction.

A CRR cut is required to infuse a big dose of liquidity which can actually also move the yields downwards if supported by OMOs. Therefore 5 October will be quite crucial for the financial markets as it will give the ultimate direction to the way things will shape up in the next two months. (The writer is Chief Economist, CARE Ratings; and author of Economics of India: How to fool all people for all times)