Comment

Repo and CRR cuts expected to ease liquidity, calm markets

The fall in foreign exchange reserves by $15.5 billion in the week ended October 24, 2008, has created a big hole in system liquidity.

On Friday, the system accessed the Reserve Bank of India’s repo window for funds of Rs 64,655 crore. The liquidity shortage drove up overnight money market rates, with call rates shooting up to over 20% levels.

The tight liquidity conditions brought about by money moving out of the country created a systemic issue that threatened to destabilise financial markets. The gap in liquidity caused by drawdown of foreign exchange reserves is so severe that even a 2.5% (effective October 11) cut in the cash reserve ratio (CRR) and a 1% reduction in the statutory liquidity ratio did not ease liquidity. The cuts effectively added Rs 130,000 crore to the system. The market expected the RBI to announce further liquidity measures to ease system liquidity.

The central bank obliged by announcing a slew of measures to address the liquidity issue. On Saturday it cut CRR by 100 basis points (bps) (50 bps effective October 25 and 50 bps effective November 8) to release Rs 40,000 crore into the system.

Further, the repo rate was reduced by 50 bps to signal a shift in policy stance from price stability to growth. The RBI made permanent the 1% SLR cut effected in September 2008 and opened a buyback window for market stabilisation scheme (MSS) bonds.

The RBI has also allowed banks to access the repurchase window for up to 1.5% of net demand and time liabilities (NDTL) for onlending to non banking finance companies and mutual funds. The RBI is also lending 1% of NDTL for 90 days to banks under a special refinance scheme. These measures are expected to ease liquidity and calm markets.

The conditions for easing monetary policy are favourable, with inflation coming off, oil prices trending down and slowing economic growth forcing central banks to cut rates. Inflation as measured by the wholesale price index came in at 10.68%, for the week ended October 18, 2008, as against market expectations of 10.80%.

Inflation had touched highs of 12.78% in August 2008. Oil prices are looking to stabilise in the $60/ barrel to $70/barrel range. Growth fears are forcing central banks to cut rates with central banks of China, USA, Korea and Japan cutting rates last week. The European Central Bank and Bank of England are expected to cut rates in their policy meet this week.

Liquidity tightened last week with bids for repo at 8% in the liquidity adjustment facility auction of the RBI touching Rs 64,000 crore. Overnight rates shot up to 20% as liquidity tightened. Liquidity is expected to remain tight in the coming weeks given the currency outflows.

Government bonds
Government bonds saw yields move down week on week. The benchmark ten-year bond yield closed the week lower by 30 bps, with the 8.24% 2018 bond closing at 7.49% levels. The government held bond auctions for Rs 10,000 crore last week.

The bonds auctioned on October 31 were a new six-year bond for Rs 6,000 crore and the 7.95% 2032 bond for Rs 4,000 crore. The cuts-off came in below market expectations, with the cut-off on the six-year bond coming in at 7.56% against expectations of 7.55% and the cut-off on the long bond coming in at 8.08% against market expectations of 8.05%. The market will go with bullish sentiments this week on the back of RBI policy measures.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were higher at the auction last week, with the cut-off on the 91-day T-bill auction on October 29 coming in at 7.44% against a cut-off of 7.19% seen in the previous week. The 182-day T-bill auction saw the cut-off at 7.38% against a cut-off of 8.68% seen in the previous auction.

The RBI is this week auctioning Rs 5,000 crore of 91-day T-bills and Rs 2,000 crore of 364-day T-bills under regular auction.

Corporate bond yields closed the week on a bearish note on liquidity fears. Ten-year benchmark bond yields were higher by 10 bps at 11.50% levels. Credit spreads rose, with benchmark ten-year AAA spreads moving up by 46 bps to close at 392 bps.

Yields at the short end of the curve closed up by 100 bps, with three-month benchmark certificate of deposit (CD) yields moving up from 12.5% levels to 13.5% levels. Corporate bonds yields are likely to be ease on the back of RBI measures.

Overnight index swaps (OIS) saw the curve flatten owing to the spike in overnight rates. The five-year OIS yield closed down by 41 bps at 6.55% levels and one-year OIS yield closed down 8 bps at 6.50% levels. The one-over-five spread flattened by 33 bps to close at 5 bps levels.

Disclaimer: The author is senior fund manager - fixed income, IDFC Mutual Fund. Views are personal.