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Pranav Thakur

The group seemed unhappy that the repo rate, which over a period of time has become the primary policy tool for the central bank to guide interest rates, was also the primary liquidity absorption window.

THE Reserve Bank of India released its working group's recommendations on sterilisation and liquidity adjustment facility (LAF) last week.

It did not contain any surprises, but it managed to cause a tremor or two in the market. As I understood it, the recommendations broadly identified two forms of liquidity, one temporary and the other enduring.

The group seemed unhappy that the repo rate, which over a period of time has become the primary policy tool for the central bank to guide interest rates, was also the primary liquidity absorption window.

Ideally, the repo window should be used for absorbing residual liquidity at the margin and should not be the primary steriliser. So the working group recommended absorption of liquidity, which seemed relatively permanent in nature, through Monetary Stabilisation Bonds (MSBs), which are nothing but short-term bonds issued by the central bank that can be traded in the secondary market.

As of now, the RBI Act does not permit the central bank to issue such bonds. Till such time that the Act is amended, the RBI could seek help from the Central government to issue the bonds instead. The money could be parked with the RBI and this borrowing would not show in the Central government's fiscal deficit.

They pointed out that the repo rate was the primary rate signalling tool and also the lower bound on overnight rates in the economy.

The current state of affairs not only robbed the central bank of its flexibility of giving a rate signal without changing the lower bound on overnight rates; it also hindered the development of a short-term rupee yield curve as all the excess money found its way in the overnight RBI repo window.

Hence they recommend daily repos for tenors of seven days and above coupled with another liquidity absorption window at a rate lower than the repo rate in the form of a statutory deposit.

The current RBI Act again does not permit the central bank to take uncollateralised deposits and pay interest. Hence the working group recommends a reduction in the rate of interest paid on the eligible cash reserve ratio (CRR) maintained by the banks and align the same with the statutory deposit rate.

It could then pay interest not only on the eligible CRR balances, but on the full cash balance maintained by the banks in their accounts with the central bank.

The statutory deposit would then be the lower bound on overnight rates and would be the residual liquidity absorbing mechanism.

The longer tenor repos and the MSBs would be the primary sterilisers. The marginal lending rate (the export and primary dealer (PD) refinance in our case) would be the upper bound on overnight rates. The repo and the reverse repo rate would be in between these two bounds.

In a cash surplus situation, there will be two rates at which liquidity can be absorbed (the repo rate and the statutory deposit rate) and one rate at which it can be injected (the refinance rate in our case).

However, in a liquidity shortage situation, liquidity will be injected at two rates (the reverse repo rate and the refinance rate) and absorbed at one (statutory deposit rate).

The group does not recommend any spread between the repo and the reverse repo rate. It just says that the central bank can absorb or inject liquidity at rates reflective of its monetary stance.

So theoretically, if there is no change in the monetary stance of the RBI, it could inject or remove liquidity at the same rate.

In other words, theoretically, the repo and the reverse repo rate could be the same as obtaining in many developed economies where the central bank targets a single overnight rate.

It also says that the overnight rate should hover around the rate at which the central bank absorbs or injects liquidity (repo/reverse repo rate).

So it is unlikely that the RBI will reject repo bids on a consistent basis only to absorb the same through its statutory deposit window. The deposit window would strictly be used for absorbing the residual liquidity.

As usual, the markets' initial reaction was to grab anything that looked like bonds but as the full report was read and understood, sobriety returned.

Going ahead, the market looks a bit range-bound unless the big PSU banks come and dump stocks to book profits for the quarter end.

Although the headline inflation has been creeping steadily and is expected to touch 6 per cent by end-December, it is a well-known fact that the base effect will push the headline number closer to the RBI forecast of 4.5 per cent by end-March.

There is enough money sloshing around still and all the traders are sitting empty.

But the market has clearly lost its earlier momentum and is prone to some aggressive profit-booking by the investor banks.

Slowly, one gets a feeling that rates might have bottomed out.

The market's apathy in the last auction suggests that it has clearly lost its appetite for the long-end.

(The author is a senior trader, interest rates at HSBC Mumbai. The views expressed herein are his own and not necessarily those of his employer.)

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