Who says interest rates are falling?

If the Reserve Bank of India (RBI) is keen to reverse its easy money policy, the least it can do is to admit to it. Recent measures taken by the central bank are clear signals to a rising interest rate scenario and this is likely to have a sustained impact on the bond and money markets, until the measures are actually withdrawn. Yet the central bank itself and many market participants have been insisting that all this is ‘temporary.’

With exchange rate worries taking precedence over growth, RBI’s recent moves have had the effect of pegging up interest rates, delivering a nasty jolt to market participants who were happily expecting further interest rate cuts, even a month ago.

The last of monetary easing measures from RBI came in the month of May when it lowered the repo rate, the rate at which banks borrow from it. The concern then was the effective transmission of such cuts to borrowers in the form of lending rates. Liquidity infusion was the quick fix that industry was banking on.

But with the Rupee heading below 60 to a dollar, and foreign investors pulling out from the debt markets, the central bank has moved quickly to stem the fall in interest rates. After putting in place many measures to curb gold imports and crack the whip on forex market speculators, the central bank seems to have come to the conclusion that it is excess liquidity that is fuelling the insatiable appetite for dollars. Mop up those Rupees and you have a steadier exchange rate, it seems to have concluded.

Playing a different tune

Between January 2010 and October 2011, RBI cumulatively raised the repo rate 13 times by a total of 375 basis points to 8.5 per cent. However in view of slowing growth in the economy, RBI then shifted to a more accommodative stance and started to reduce the repo rate from April 2012. There has been a cumulative 125 basis points reduction till date. However, these rate cuts have not meant much to the borrower. The base rates of banks, to which their lending rates are linked, only came down by 30-50 basis points over the year.

Till recently banks were hopeful of the central bank freeing up more liquidity, in the form of cutting their cash reserve ratio requirements. But RBI has instead turned its focus on keeping bond yields high and attractive enough for foreign investors to stay put in the domestic bond markets.

Convinced that excess liquidity was being used by banks to facilitate speculative positions in the forward exchange markets, RBI has announced many liquidity tightening measures since last week. First, it capped the amount banks can borrow from overnight markets through the liquidity adjustment facility (LAF). Second, it increased banks' cost of borrowing short term money through the Marginal Standing Facility (MSF) by 200 basis points to 10.25 per cent. In addition, the government announced the sale of government securities to the tune of Rs 12,000 crore, soaking up yet more liquidity from the system.

These measures immediately sparked off a sharp rise in short term interest rates. The yield on one-year certificates of deposit (CDs), rates at which banks source money from corporates and individuals, have soared by a whopping 200 basis points and are now at 10.3 per cent. The government itself is borrowing at higher rates.

The 364-day treasury bill was auctioned at a cut-off yield of 10.5 per cent on Wednesday. Only a few weeks ago, before these measures, the cut-off yield hovered at 7.5 per cent on similar treasury bills.

This Tuesday, RBI has further tightened liquidity. Halving the limit on borrowing by banks through LAF, the central bank has set a daily limit of 0.5 per cent of net demand and time liabilities. Banks can therefore effectively borrow only Rs 39,000 crore from the LAF window now, compared to the average of Rs 58,000 crore in the last two months. For their remaining requirements, banks will have to borrow from the MSF window at the much higher rate of 10.25 per cent. This pegs up borrowing rates for banks by 100 basis points, surely a sharp spike over just a week.

This is not all. While banks so far were rooting for a cut in the cash reserve ratio (CRR) to give them headroom to lower deposit rates, they now have to contend with just the opposite.

Banks will now be required to maintain a minimum daily CRR balance of 99 per cent of the requirement, against 70 per cent earlier.

CRR requirements were until now reckoned only every fortnight, giving banks breathing space to play around with the balances in the interim period. But now, they will have to maintain these balances everyday.

This will impact banks in two ways. One, banks will be forced to maintain an additional buffer, as money markets close much before the banks’ daily activities do. Thus if their average cost of borrowing is around 6 per cent, then for every rupee that they hold in idle cash, they will have to bear higher cost. Remember that banks earn zero interest on cash maintained with RBI. Two, this will effectively increase the CRR requirement by another 40-50 basis points.

In effect, therefore, RBI has insidiously raised both interest rates and CRR requirements, even before it declares its monetary policy next week.

The repo rate may technically be at 7.25 per cent. But taking into account all recent measures, the effective repo rate for banks is 75-100 basis points higher. These were the levels we saw in the fag end of RBI’s earlier tightening policy. The yield on the 10 year government bond, which had plunged to 7.1 per cent in May on expectations of a rate cut, has zoomed by nearly 130 basis points and hovers at 8.4 per cent. The last time we saw these levels was in January 2012, before RBI embarked on its monetary easing policy.

Temporary, really?

Market players have chosen to look at the silver lining in all this, by insisting that these measures are only fire-fighting measures to rescue the Rupee. But going by the limited impact that all these moves are having on the Rupee and by the RBI’s persistent efforts to reverse the slide, the signals are all to the contrary.

If the RBI was only looking to bolster short term rates, why announce these measures right after announcing the sale of two-year bonds? With recent developments, this bond auction is quite unlikely to happen at cut off yields of less than 9 per cent.

Again if these measures are ‘temporary’, then why has RBI chosen to sell long-term government securities (13 to 17 year) through open market operations at 8.2 to 8.5 per cent amidst all this action? The RBI confused market participants a bit more at this juncture by accepting bids only for Rs 2532 crore out of the Rs 12,000 crore sale. Even the regular bond auction of Rs 15,000 crore, saw primary dealers buy bonds around Rs 3500 crore due to the liquidity scenario.

After lukewarm response from these auctions, RBI has now announced the auction of Rs 3,000 crore each of 28-day and 56-day government cash management bills that are used by government to tide over its temporary cash requirements.

On Monday, foreign investors lapped up fresh limits for investment in government securities but at a small premium. This clearly signals a ‘wait and watch approach’ by them.

In the meantime, banks will clearly have to grapple with yet more challenges, on top of slowing loan growth, sluggish deposit inflows and rising bad loans. The only option through which banks can readily raise liquidity is by offloading their hoard of government securities.

Banks are today holding a much larger proportion of government securities than mandated by statute. But if they decide to sell their gilts, they will only be shooting themselves in the foot. For this will only add to the upward pressure on market rates.

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