Should the market worry about liquidity?

The bond market is worried about liquidity. The inversion of yield curves clearly suggests that liquidity will get tighter and overnight borrowing costs will climb. The overnight index swap (OIS) curve inverted last week with the five-over-one swap spread inverting to a negative eight basis points from a positive 10 basis points week on week. The sharp rise in yields in the one-year OIS implies that call money rates will go up much higher from current levels of 7.4%.

The OIS is indexed to the overnight call money rate and hence any expectations of rise in call money rate will lead to a rise in one-year OIS yield. Call money rates rise when liquidity is tight and demand for overnight funds outstrips supply.

The Reserve Bank of India (RBI) lends funds to banks and primary dealers through the repo window. The rate at which they lend funds is the repo rate, which is the benchmark signalling rate of the RBI. The repo rate is at 7.25% and the market is borrowing around Rs75,000 crore on a daily basis from the repo window. Expectations of rise in call money rates occur when the market believes that the system will exhaust the repo window and will then scramble to borrow in the call money market. However, for the repo window to become fully utilised, liquidity has to tighten to levels of Rs150,000 crore and above. Banks also have an additional facility called the marginal standing facility, or MSF, provided by the RBI where they can borrow 1% of their net demand and time liabilities at 100 bps over the repo rate i.e. at 8.25%. Banks can borrow Rs50,000 crore through the MSF if required. Hence, for call rates to rise over 8.25%, liquidity will have to tighten to Rs200,000 crore and that is not likely to happen anytime soon.

The reason that the market is worried on liquidity is due to the advance tax outflows of around Rs45,000 crore expected in June. Given that the system is borrowing Rs75,000 crore on daily basis from the RBI, advance tax outflows will take down liquidity to Rs120,000 crore. However, advance tax money comes back into the system through government spending. The government has been a heavy spender in April and May and is net drawn down from the RBI by Rs21,000 crore as of May 20 over and above the issue of cash management bills of Rs32,000 crore. The RBI issues cash management bills when the government has exceeded its overdraft limits. Cash management bills of ¤20,000 crore will mature end-June and that money will come into the system. Money will also come into the system when the government redeems Rs37,000 crore of 9.39% 2011 bonds maturing on July 2. As long as the government is a net spender, what goes in comes out and is liquidity positive not liquidity negative.

The market will have to tide over a short period of tight liquidity, largely around mid- June. Liquidity will then come back to normal and overnight rates will trade around repo rates of 7.25%. The market sentiments being poor, yields get amplified on worries rather than facts and that in itself is a signal for the markets to start unwinding any shorts created on perceived liquidity worries.
Government bond auction

The government auctioned Rs12,000 crore of bonds last week. The bonds auctioned were the 7.83% 2018 bond for ¤4,000 crore, the 7.80% 2021 bond for Rs5,000 crore and the 8.30% 2040 bond for Rs3,000 crore. The cut-offs came in at 8.54%, 8.43% and 8.66%, respectively. The government is scheduled to auction Rs12,000 crore of bonds this week.

arjun@arjunparthasarathy.com