Money market instruments gain traction as market waits for monetary transmission to kick in

The overnight borrowing rates in the money market has declined.

By Anil Gupta  

The volume of commercial papers (CPs) outstanding reached a high of Rs 4.79 trillion as on February 15, 2025, the highest level since October 31, 2019 and the volume of certificate of deposits (CDs) touched an all-time high of Rs 5.19 trillion as on February 7, 2025.

RBI’s policy rate should trend downwards

With a recent cut in the policy rates by the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) and sizeable liquidity infusion measures taken by the RBI, the overnight borrowing rates in the money market has declined to 6.26 percent as on February 24, 2025, compared to the daily weighted average of 6.65 percent in December 2024.

With the inflation expectations remaining within the MPC’s tolerance band in addition to the need to revive the economic growth, the market expectations are running high for another rate cut in the upcoming MPC meeting in April 2025. This shall result in a further decline in the overnight rates from April 2025, signifying lower interest rates in the economy.

For now, short-term borrowings offer flexibility

In the near-term, many of the large corporates who borrow from diversified sources, including banks, debt capital markets and CPs, are expected to shift towards short-term borrowings, including the money market instruments such as CPs. Such short-term borrowings may offer them flexibility to replace these with cheaper long-term borrowings later, when these long-term rates decline.

While the floating rate loans of the banks are linked to external benchmarks (such as REPO rate or T-bill rates), a sizeable portion of the floating rate loans are linked to another benchmark, i.e. Marginal Cost of Fund-based Lending Rate (MCLR), which generally re-prices with a lag of two or more quarters. This is primarily because the bank deposit rates (especially for tenor more than 1 year) also re-price downwards with a lag.

Accordingly, the volume of CP outstanding is expected to remain elevated compared to the recent past, till the rate transmission happens in the long-term borrowing costs for corporates.

On the other hand, while the banks have benefited from the recent repo rate cut and various liquidity infusion measures taken by the RBI, the core liquidity of the banking system remains in a deficit of almost Rs. 2 trillion as on February 24, 2025. The liquidity deficit in the banking system is an outcome of the foreign capital outflows and the RBI’s intervention to support the exchange rate.

Banks may opt for wholesale deposits right now

Despite deficit liquidity conditions, which are likely to prevail for the next few months, the banks could refrain from hiking retail deposit rates, as the expectations are that the deposit rates will be lower, going forward. Hence for the time being, the banks could continue to raise bulk deposits (including CDs) to meet any temporary funding requirements. Further, these bulk deposits or wholesale deposits generally re-price faster and with the recent decline in overnight rates, these could come at a competitive price compared to retail deposits.

Limitations imposed by LCR

However, reliance on these bulk deposits for funding growth has had its own limitations for the banks after the introduction of the liquidity coverage ratio (LCR) framework in January 2015. Under the LCR framework, these bulk deposits attract higher outflow rates, thereby pulling down the LCR, hence the banks with high share of bulk deposits need to deploy a larger share of these in liquid assets like Government securities, to recoup their LCR.

For the deposits raised through the CDs, a bank will require a 100% liquidity backup in the last 30 days of the CD maturity. Accordingly, while the absolute amount of CDs has reached an all-time high, its share of deposits remains relatively lower at 2.3 percent of the total deposits compared to over 8 percent of the total deposits over a decade ago when the LCR framework was not applicable.

Similarly, in the CP markets, non-bank finance companies (NBFCs), including housing finance companies (HFCs), are large issuers of CPs. With a similar LCR framework applicable for them from December 2020 (for NBFCs) and December 2021 onwards (for HFCs), the volume of CPs outstanding has remained lower than the all-time high of Rs. 6.4 trillion as on September 15, 2018.

(Anil Gupta is Senior Vice President and Co-Group Head – Financial Sector Ratings - ICRA.)

Views are personal and do not represent the stand of this publication.