In a major attack to clamp the further decline in the Indian rupee against the US dollar, the Reserve Bank of India (RBI) on Monday late evening issued a series of liquidity measures. Bonds yields are now expected to go up while a dearer rupee is likely to create a squeeze in funds availability. Consequently, the demand for rupee will rise.
"The market perception of a likely tapering of US quantitative easing has triggered outflows of portfolio investment, particularly from the debt segment. Consequently, the rupee has depreciated markedly in the last six weeks. Countries with large current account deficits, such as India, have been particularly affected despite their relatively promising economic fundamentals," RBI said in release underscoring the need for immediate measures to restore stability to the foreign exchange market.
The Indian rupee hit record low at 61.21 against the greenback on July 8 this year. Since last two month, it has lost more than 15 percent due to erosion of overseas investment in India.
The central bank restricted banks' borrowing through liquidity adjustment facility (or a window to borrow funds from RBI called LAF) to the tune of 1 percent of total deposits or Rs 75,000 crore. It will be effective from July 17 when onwards, banks have to look for other options to meet their overnight fund requirements if the level reach the stipulated mark.
LAF is the combination of two auction routes: repo and reverse repo. While banks borrow from repo currently at 7.25 percent, they park their excess liquidity via reverse repo rate at 6.25 percent.
Accordingly, RBI raised the interest rate of Marginal Standing Facility (MSF) by 100 bps to 10.25 percent as against 9.25 percent currently. Hence, the difference between repo rate and MSF stands at 300 basis points compared with 200 bps currently. Banks can borrow money pledging their excess SLR (Statutory Liquidity Ratio) bonds. Most of the banks are holding excess SLR above 23 percent. Hence, lenders can borrow money using MSF route.
"RBI had two options: a policy rate hike or a squeeze in rupee liquidity," Moses Harding, an astute treasury expert with rich banking experience told moneycontrol.com.
"The central bank opted for the latter. Bond yields may go up to 7.80 percent. The impact will be much severe than direct rate hike when LAF is restricted at 75,000 crore when excess SLR is at 4-5 trillion. The rate differential between repo and call market may now widen up to 30-40 bps compared with 5-10 bps currently. Banks would use MSF option to raise short term funds when the call money market rate will rise above 10 percent," he said.
As of now, the benchmark call money market rate is hovering around 7.35 percent. The 10-yr (2023) bond yield is moving around 7.50-7.60 percent range. The relation between bond yields and prices is inverse. Banks' net borrowings come in the range of Rs 80,000 crore to Rs 1 lakh crore. In MSF market, banks need to pledge SLR bonds to mop up funds.
Banks are mandated to invest in government securities to the tune of 23 percent of their total deposits.
Measure Three & need:
Perhaps realising the impact on the bond market, the RBI announced an open market (sales) operation (OMO) of Rs 12,000 crore on July 18, 2013. This will ensure more flows of government papers in the market especially when bond prices are likely to fall due to rise in yields.
"While the announcement of OMO is a good sign, I am yet to be convinced about the merits of liquidity measures to check rupee's volatility. A straight 25 bps hike in the policy rate would have lured foreign institutional investors to invest in India and thereby, stemming rupee's free fall with fresh dollar inflows," Ashutosh Khahjuria, president - treasury, Federal Bank.
With all these measures, the central bank will continue to closely monitor the markets, the liquidity situation and the macroeconomic developments. It will take such other measures as may be necessary, consistent with the growth-inflation dynamics and macroeconomic stability, said RBI, which will announce its first quarter (April-June) monetary policy on July 30.