Some more liquidity, please

By rolling back a steep increase in short-term rates, opening the floodgates on FCNR deposits, and infusing liquidity through bond purchases, the Reserve Bank of India has been signalling to banks and the bond markets that it isn’t entirely anti-growth. But for these measures to be really effective, the central bank needs to do much more.

With another 50 basis point cut in the Marginal Standing Facility (MSF) rate this week, the RBI has kept the promises made in its September monetary policy. Of the 200 basis point spike in MSF rates in July, 125 basis points have already been rolled back. The central bank has also obligingly given the markets cues on rate direction by assuring them that the MSF rates would “walk down” further.

Cost relief for banks

Banks do seem better off after these measures, but are still not back to where they started.

First, there are the interest rates. The key policy rate — the repo rate — at 7.5 per cent is now 25 basis points higher than in July. With the MSF rate at 9 per cent, the gap between the cost of banks’ borrowing from the liquidity adjustment facility (LAF) and the MSF has narrowed to 150 basis points, against 300 basis points just after the July measures.

This means a significant decline in costs. Three-month certificate of deposits (CD) rates, the rates at which banks borrow from institutions, after rising sharply from 8 per cent to 10.5-11.5 per cent post-July, have clambered down to 9 per cent after Monday’s cut in MSF rate.

After the partial roll-back of higher rates in the September policy, banks’ costs of borrowing had declined by 30 basis points, a saving of about Rs 280 crore a day. With a further 50 basis points cut in MSF rates this Monday, their average cost has come down by yet another 30 basis points or Rs 320 crore a day. Banks will continue to see more cost savings as MSF rates go down further as the RBI has promised.

Long-term interest rates, however, remain stubbornly high. Mirroring the repo rate increase, the 10 year G-Sec yield which is at 8.5 per cent, is 100 basis points higher than it was before July. Interest rates on 10-year corporate bonds today are still 90 basis points higher than pre-July levels at 9.7 per cent.

Corporate effect

Companies have felt the worst effects of the July tightening measures on their working capital needs. As short-term borrowing costs for companies went up by almost 2 percentage points in a month, the resulting liquidity crunch led to a rise in defaults and downgrades by rating agencies.

The corporate bond market also saw rates rise sharply. The interest rates on AAA rated corporate bonds went up by 100-160 basis points across maturities of one-, three-, five- and ten-year bonds.

Aside from rates going up, there have been other implications as well. With a spillover effect on the long-term rates, corporate bond issuances practically came to a standstill. In the April-June quarter of 2013-14, companies raised Rs 1.1 lakh crore by way of private placement. This shrank to just Rs 14,200 crore in July and August put together according to the data available in the Securities and Exchange Board of India (SEBI) web site.

The other consequence of this is that riskier borrowers have been accessing the public markets. Recent public issues of non-convertible debentures by companies have only been from AA rated borrowers. This is because banks prefer to lend to higher rated companies as the lending risk is minimal. Thus, higher rated companies have been able to raise money from banks easily.

But companies raising money from public markets have had to offer much higher rates than before. For instance, Shriram Transport Finance recently offered 35 basis points more on its bonds than it did on its earlier issue in July.

Unless liquidity is released further, corporate bond issuances will not pick up. Most of the companies will approach banks for loans. Adequate liquidity is required to ease up the working capital cycle of companies and reduce credit risk.

What’s ahead?

With short-term rates down and long-term rates hardening, what can the central bank do to cool bond markets and facilitate growth?

One, it may need to maintain the repo rate at levels not higher than 7.75 per cent. As of now, markets have only factored in another 25 basis points hike in repo rates. Any hike in excess of this will hit bond prices significantly and increase bond yields. The 10-year G-Sec yield, which is hovering at 8.5-8.7 per cent, can shoot up to 9 per cent or even more. That will take us back to April 2012 when the RBI had just started its rate easing.

Two, liquidity will remain critical to a revival in corporate fortunes. While banks have increasingly seen more cost savings after MSF rates have been reduced, the pass-through of this benefit to customers by way of lower lending rates will depend on whether banks have liquidity.

Yes, the special swap facility introduced by the RBI on FCNR (B) deposits and raising limit on overseas borrowing has helped liquidity to some extent. However, there are other curbs that still exist. For instance, the cap on the banks’ borrowing though LAF at Rs 39,000 crore a day is a big constraint for banks.

Currently they are borrowing close to 60 per cent of their requirement from the MSF window at higher rates. These borrowings will rise as we progress into the busy season for credit.

Three, if the RBI is keen to re-establish the repo rate as the key signalling rate, as it emphasised in its September policy statement, the cap on LAF borrowings will need to go away completely.

Interest rates on recently announced short-term repo are likely to be based on bids received in the auction. Given that banks are so short of liquidity, the rates are more likely to be at the higher MSF rate rather than the repo rate.

Hence, to really roll back its July measures and solve the liquidity woes of banks and companies, the RBI should infuse money through the purchase of bonds and remove the cap on LAF borrowings. After all, with the immediate concerns on the current front abating, there is good reason to do this.

The current account deficit which was at $21 billion in the April-June quarter is estimated to have come down significantly in the September quarter. With the new debt ceiling issue, taper fears have also receded to the background. With the rupee range-bound, there is certainly more leeway now to ease up liquidity.

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