RBI's liquidity clean-up to push up bond yields

The apex bank has become more aggressive in absorbing liquidity since note ban, has sold Rs 90,000 cr bonds to remove excess liquidity

One year after demonetisation was announced, banking system liquidity is still in the surplus territory even as the central bank and the government used all that they had in their means to neutralise the surge of deposits in the banking channel.

Only in the Reserve Bank of India’s (RBI’s) liquidity adjustment facility alone, banks parked their surplus liquidity in excess of Rs 5 lakh crore on November 25, 2016, prompting the RBI to announce 100 per cent cash reserve ratio (CRR), from the normal four per cent, for incremental deposit mobilised over a certain period. CRR is the share of deposits banks maintain with the central bank free of cost.

Data compiled by rating agency Icra show at its peak, net absorption of liquidity - through various instruments by the central bank and the government — reached about Rs 8 lakh crore by early January, indicating the extent the banks put their money in the central bank.

The central bank has become more aggressive in its liquidity absorption exercise since then, and has sold Rs 90,000 crore of bonds in the open market to remove excess liquidity. Besides, between December 2, 2016, and March 13, 2017, the government issued cash management bills (CMBs), or specialised short-term treasury bills, issued under the market stabilisation scheme (MSS) to neutralise excess liquidity. At its peak in mid-January, CMB outstanding was worth more than Rs 5 lakh crore.

The daily average liquidity absorption under the liquidity adjustment facility (LAF) of the RBI declined to Rs 2.74 lakh crore during the second quarter (Q2) of FY18, from Rs 3.52 lakh crore in the first quarter (Q1). Including CMB and treasury bills issued under MSS, the daily average surplus liquidity eased mildly to Rs 4.38 lakh crore in Q2, from Rs 4.58 lakh crore in Q1, said Icra in a research note.  

The reason why it was important to drain excess liquidity was that it would have stoked inflation, which the central bank is fighting to keep under four per cent. However, a surplus liquidity regime also distorts the transmission of the RBI policy rates. Surely enough, in response to the central bank’s cumulative 200-basis points (bps) policy rate cut, bank lending rates have fallen by about 120 bps. One reason cited by banks was that they cannot cut deposit rates drastically even as people continue to park their money. And since deposit rates have not fallen, lending rates cannot fall too, they say.

Draining liquidity would help the central bank get a grip on the situation and direct banks as the situation prevails for an effective transmission.

But, according to Soumyajit Niyogi, associate director of India Ratings and Research, draining liquidity would make it difficult for banks to cut rates. It is a dilemma for the central bank that wants the banks to lower lending rates faster.

Even as deposit growth shot up, credit growth for the most part of last year remained in mid-single digits. Only now, there are some signs that credit growth is picking up. Credit growth is now at around 7.5 per cent, whereas deposit growth is about 8.7 per cent and slowly the growth rates are converging.

As credit and deposits growth converge, liquidity will tighten even further, said Nomura in a report. 

“We expect this trend of convergence between credit and deposit growth to continue. A cyclical recovery and higher commodity prices should boost working capital needs, while the availability of growth capital after the recently announced recapitalisation plan should also enable public sector banks to extend additional loans,” Nomura said.

This would also mean an improvement in credit-deposit ratio to a near normal level of 75 per cent, from 72.6 per cent in mid-October and would “tighten banking system liquidity incrementally,” Nomura said.

The implication of this is the hardening of bond yields. From 6.41 per cent in end July, the yields on the 10-year bond have risen to 6.94 per cent and bond dealers expect the yields to cross the seven per cent mark quite soon. 

However, according to a senior bond dealer with a foreign bank, the RBI may still want to have a high yield for fear of outflow from the debt segment.

“The US 10-year yields have topped to 2.4 per cent and the interest rate there is scheduled to go north. Bank of England, too, recently hiked rates. If India has to keep the investors engaged, it will have to offer higher yields and that’s what the RBI is probably doing,” said a bond dealer.