Tight liquidity conditions have eased, now what?

Liquidity, which was strained for most of the last eight months, has eased at last on the back of the Reserve Bank of India (RBI) bond buybacks and government spending.

The RBI had bought bonds for over Rs55,000 crore in December and January to add primary liquidity to the system. The government has drawn down most of its cash balances parked with the RBI.

Government balances with the RBI have come down to Rs27,000 crore from peaks of over Rs100,000 crore.

Banks are drawing down around Rs70,000 crore from the RBI on a daily basis, but this should be looked at in conjunction with the banks’ investments in mutual funds which stands at around Rs70,000 crore.

Mutual fund investments are liquidity on call for the banks and they will draw down the funds whenever required. Banks are content arbitraging between borrowing from RBI at repo rate under the liquidity adjustment facility window at 6.5% and parking the money in liquid funds which are giving returns of between 7.6% and 8.10%. 

The liquidity outlook is, however, still clouded as indicated by rates on money market instruments. Three-month certificate of deposit (CD) rates are at 9.80% levels while one-year CD rates are at 10% levels. The levels are at highs for the year and are staying high due to worries on further liquidity tightness.

The financial year-end is when demand for liquidity from the system is at its highest as borrowers and lenders balance their books.

Liquidity worries will not go away unless the government starts spending aggressively and even draws down on its overdraft facilities with the RBI.

Government spending is negative for bond yields as the market will start worrying about fresh supply coming in from April 2011.

Expectations of the government going into next fiscal with healthy cash balances are going away and the government is expected to frontload its next fiscal year’s borrowing to meet its need for funds.

The expected fresh supply coupled with inflation expectations at elevated levels will push up bond yields. Inflation for January 2011 is expected to come in at 8.2% levels and end-March inflation is forecast at 7% levels.

The RBI has clearly expressed its worries on inflation and will focus more on inflation management in the coming policy reviews.

Government bond yields fell last week on easing liquidity and easing supply. Benchmark bond yields fell 5 bps with the yield on the well traded 8.13% 2022 bond closing last week at 8.21% from levels of 8.26% seen in the week previous to last.

The government has one more auction to go to make up for the reduction in sizes of some earlier auction after which the supply ends for this fiscal. 

The market now has to start worrying once again on government finances. The government’s subsidy bill has gone up to over Rs65,000 crore.

The government has still not committed to pay the full subsidy to the oil marketing companies but the bill is going up everyday. The government does not have the comfort of excess balances with the RBI and the funding of the subsidy will pose a problem.

Government bond auction
The government auctioned Rs10,000 crore of bonds last week. The bonds auctioned were the 7.49% 2017 bond for `3,000 crore, the 8.08% 2022 bond for Rs4,000 crore and the 8.26% 2027 bond for Rs3,000 crore. The cut-offs came in at 8.15%, 8.25% and 8.54%, respectively.

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