The Hindu Business Line : Call market volatility points to hard RBI choices

Chennai June 4 A lot more needs to be done for the development of the money market in India, the Reserve Bank of India's latest Report on Currency & Finance (2005 - 06) says.

The ink on the report would have barely dried when evidence of the amount of work needed to be done in the money markets gets highlighted. The huge swings in inter-bank call money rates in the last six months point to the formidable task in money market development in India. It has been a roller coaster ride - call rates zooming to highs of 60 per cent plus and plunging to the sub one per cent levels currently - in the overnight money markets.

Averaging the rates over a period of time and also weighting them for the amount of borrowing / lending which has actually taken place could actually smoothen the curve. But the fact that aberrations such as 60 per cent plus rates and sub one per cent rates still happen and that too in a short span of around 3-4 months is a clear pointer to the inefficiencies holding out in the Indian money markets. Such swings in the overnight rate not only mar the record of the central bank in dynamic management of system liquidity. They could also adversely affect the formation of longer (longer than overnight) term interest rate expectations.

On such expectations and views does the development of the market - be it a term money market, a short-term yield curve and so on depend, since given a degree of stability in the call market, market players could take courage in forming and implementing interest rate views.

The average daily turnover in the overnight inter-bank call money market is around Rs 20,000 crore. If we add up the activity in the collateralised segments of the money market (around Rs 60,000 crore together in the CBLO and market repo segments), the total daily turnover comes to around Rs 80,000 crore.

On the banking sector's aggregate deposit base of around Rs 25,00,000 crore, this amounts to just 2 or 3 per cent. That is, around 2 per cent of the total deposit base is the average requirement of short-term or overnight liquidity. Viewed thus, the gyrations in the call money rate should not be a matter of much concern, as at the margin, the costs may not be impacted much.

But, the skewed distribution of liquidity in the banking system (a set of regular borrowers and a set of regular lenders) and (more generally) the presence of competitive forces ensure that the effect on the marginal cost of borrowing soon spreads into the general structure of rates on both the borrowing and lending sides of banks.

Cap on LAF absorption

The proximate cause of the recent crash in call rates is on account of the RBI capping its absorption (through the LAF) of daily money market surplus liquidity at Rs 3,000 crore. This decision of a quantum ceiling on liquidity absorption has coincided with a slight slowdown in asset side growth of banks. Bank credit growth has moderated somewhat to around 27 per cent as of mid-May against 29.50 per cent y-o-y at the end of March. The lagged impact of the RBI's earlier monetary tightening as well as a seasonal dip in credit expansion (the slack season beginning April - though it is possible that the Indian economy has outgrown the slack /busy season differentiation) are possibly damping asset side growth in banks. Growth on the funding side, though, appears to be brisk, boosted by the previous round of rate hikes for savings. The genesis of the money market surplus noted from around the second half of May is probably explained thus.

Business growth

It is possible that a pick up in lending activity consumes the excess liquidity floating around currently. But, it is also probable that the slowdown in credit which we have witnessed from late March continues for some more time, as the pricing which has been built into liabilities/ assets from the earlier round of rate hikes continues to have an impact. In that scenario, one could witness a slightly more extended period of extremely easy money market rates.

The key issue, though, could be the longer term impact of an extended period of easy money market rates now. This could undermine the RBI's stated goal of transiting to a lower level of inflation through the course of this year and jeopardise any prospects of interest rates softening towards the close of this year.

Indeed, it is possible that a prolongation of the ultra low money market rates which we are seeing currently compels the RBI to slam hard on the monetary brakes in the third or fourth quarters of this year. Avoiding that possibly calls for the RBI to ensure that money market rates move in the corridor it has set - 6 to 7.75 per cent. Such a defence of the money market corridor, not only in the present circumstances, but also on a continuous basis, could go a long way in money market development.

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