As deficit collapses, short bonds and funds will do well.
Liquidity conditions have eased considerably over the last couple of days.
Liquidity, as measured by bids for repo in the LAF (liquidity adjustment facility) auction of the Reserve Bank of India (RBI), has eased from an average deficit of around Rs65,000 crore seen during the last one month to a deficit of just Rs11,700 crore as of July 4, 2013.
Any further easing could lead to surplus and the overnight money market rates could drop by 100 basis points from the repo rate of 7.25% to the reverse repo rate of 6.25%.
So why has liquidity eased? Because of government spending and falling demand for funds from banks.
The government has drawn down on its surplus cash of around Rs100,000 crore that was parked with the RBI, injecting funds back into the banking system.
Credit growth has been negative in the first quarter of fiscal 2012-13 due to a weakening economy and poor business sentiment.
India saw new orders decline in June for the first time in four years, while output declined for the second consecutive month.
Credit growth was a negative Rs37,350 crore in the April-June (as of June 16, 2013) period.
Deposit growth was positive at Rs14,640 crore in the same period. Falling credit and rising deposits is positive for the banking system liquidity.
The question is, will liquidity continue to ease despite a weak rupee that is trading at record lows against the dollar?
The RBI has refrained from large-scale intervention in the currency markets and hence liquidity is not under pressure on that front.
Foreign institutional investors (FIIs) have sold rupee debt worth over $4.5 billion over the last one and half months, which is negative for liquidity.
However, given that liquidity conditions have eased in the system, FII selling has not impacted negatively.
One reason could be that FIIs did not convert their bond sales into dollars and kept it in rupee to reinvest the money in bonds at a later stage.
Liquidity conditions could ease further going forward as bank demand for funds go down on the back of lack of credit growth.
Banks could also see deposits growing as savers take money out of unregulated investment products on worries of scams and ponzi schemes.
The State Bank of India has seen strong deposit growth of 60% in the April-June 2013 period due to this fear factor.
RBI’s regulation on non-banking finance companies (NBFCs) floating bonds to raise funds is a positive factor for liquidity.
NBFCs were regular issuers of bonds to the retail as well as institutional market and the RBI has placed restrictions on their fund raising through this route.
Banks will benefit from the restriction.
Surplus liquidity is also highly positive for bond yields at the short end of the yield curve.
Overnight rates falling by 100 basis points will lead to cash-surplus banks and mutual funds rushing to buy money market securities and short maturity bonds to earn higher yields.
Falling yields at the short end of the curve will benefit short-term bond funds as such funds are invested in short maturity bonds.
Arjun Parthasarathy is the editor of www.investorsareidiots.com, a website for investors
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