What is the impact of the changes in the liquidity adjustment facility

ISSUE

Term money mart seed sown

Mohan Shenoi
Treasurer,
Kotak Mahindra Bank

The Reserve Bank of India's (RBI) report on liquidity adjustment facility (LAF) suggested structural changes with a view towards a more efficient development of the money market.

The most significant of these is the replacement of the daily overnight repo auctions by a 7-day repo auction at a fixed rate of 4.5 per cent (as opposed to the currently existing variable rate repo auction). The 14-day repo auction will continue for the moment but will ultimately be phased out.

Under the old system, liquidity injection to the money markets from the RBI was performed through the normal/ back-stop refinance and reverse repo auctions. While liquidity injection via the normal refinance was at the bank rate of 6 per cent, supply of funds through the back-stop route was at the reverse repo rate of 6.5 per cent.

To prevent liquidity injection into the system at multiple rates, the RBI has reduced the reverse repo rate by 50 basis points (bps) to 6 per cent.

Apart from the fact that now liquidity can be injected into the system at a single rate (the reverse repo rate), it also shrinks the money market corridor (the difference between the rate at which liquidity is injected and the rate at which liquidity is sucked out) to 150 bps from the current 200 bps.

However, with the short-term signalling device of the RBI continuing to be the repo rate, the shrinkage of the corridor is unlikely to have major impact on the money market rates.

The implication of the discontinuation of overnight repo auctions for cash surplus entities is that cash management decisions and the assessment of liquidity needs in the intervening period will have to be taken up with greater care.

Before the banks gain comfort with the new system and develop its own assessment skills, the quantum of bids at the 7-day repo auctions are likely to be on the lower side.

This means that in the adjustment phase to the new system, the pressure of funds supply in the call money market will be enhanced, creating the potential of depressing the overnight rate to around 3.50-4 per cent.

The other side of the coin, entities committing excess funds to 7-day LAF is also a possibility but is not being viewed as a reality as players have been cautious in committing only about Rs 2,500 crore in the daily 7-day LAF.

With players deriving more operational comfort and with liquidity mop-up via the market stabilisation scheme to start soon, call rate would settle back at around the 4.25-4.40 per cent band.

The absence of a daily overnight avenue to park money along with the progressive weaning out of non-bank participants from the call market can lead to the development of a term/ notice money market "" to start with at the very short end of the curve.

Risk averseness in parking funds in the 7-day repo can lead to surplus funds position that can be lent to counterparties for a period between overnight and 7-day, depending on the liquidity assessment of the lending party.

The genesis of the development of a term/notice money market in India is thus created, at least till 7 days, which may over a period of time extend to 45-60-90 days. With the 7-day repo rate fixed at 4.5 per cent, players will lend for lower duration at sub-4.50 per cent, creating an upward sloping term money yield curve.

Positive for now, negative later

R V S sridhar
VP-Trading,
UTI Bank

The build-up of liquidity in the system in the last two years, thanks to the deluge of dollars, is coming in the way of effective monetary management by the Reserve Bank of India (RBI). It has been absorbing huge sums through its daily liquidity adjustment facility (LAF) auctions.

In order to remove the influence of such a liquidity overhang, the RBI has introduced market stabilisation bond (MSB) which aims at sucking out surplus funds. It has also decided to modify the current LAF scheme.

The change in the LAF scheme is thought necessary to improve the efficacy of LAF as a signalling tool, place the repo rate correctly in the interest rate corridor, distinguish between sterilisation of temporary and permanent flows and to moderate the market's preference of the LAF as the first choice when it comes to deploying funds.

Arising from these concerns, the RBI's internal group had suggested that banks having surplus funds might keep these with RBI at a lower rate compared with the current repo rate in a standing deposit facility.

The RBI has also introduced 7-day repos against the previous overnight repos. The aim of these modifications is to make the LAF scheme more enduring in its impact. It is likely that RBI may conduct longer or shorter period repos if the situation warrants.

The objective of the new LAF scheme seems to be to ensure that overnight rates stay around the repo rate and thus increase the signalling status of the latter. The other objective is also to establish the LAF scheme as a liquidity management tool at the margin as MSB would suck out enduring liquidity.

Clearly, the RBI is looking to moderate the influence of forex flows on the interest rates in the system. Debt markets have rallied almost continuously in the last three years, save for the occasional blip, on the back of the liquidity overhang.

Analysts have often worried whether other macro variables such as inflation rate, etc. have no role to play in determining interest rates and have warned that treasury profits could vanish with a bang.

The revised LAF along with the MSB would go a long way in controlling the influence of liquidity on interest rates. But, there are other worries. It is unclear what would be effect of liquidity getting locked up in the 7-day repo. Would it lead to sharp movements in call rates if overall liquidity dries up slowly?

To be sure, RBI's report says that it would be well equipped to manage a deficit liquidity situation as well as a surplus liquidity situation. The latter situation could be managed by unlimited collateralised lending under LAF.

It appears that the LAF corridor would move down and up depending on surplus and deficit states of the liquidity in the system.

Optimists feel that since the repo rate would fall in the middle of the corridor, the call rates would actually move down due to the current surplus liquidity situation.

However, realistically speaking, the modification to the LAF and the introduction of the MSB would remove the helplessness of RBI seen earlier, and in the long run help the central bank to guide call rates to a sustainable level taking into view other macro variables.

Thus, outcome of these instruments is likely to be slightly positive in the short term but and slightly negative in the long term.