Action replay?

Liquidity in the money markets has improved substantially in the last few days, and call money rates are back to levels near the reverse repo rate. Banks have once again started parking surplus funds in reverse repos with the RBI, after a few days of being forced to access the repo market for funds.

Three main factors are responsible for liquidity reappearing in the money markets: the resumption of government spending, the maturing of market stabilisation treasury bills, and dollar purchases by the Reserve Bank.

Dealers point out that the central government had been accumulating funds with the RBI and the drawing down of those funds, which has begun, will get money flowing back into the banking system. The maturing of market stabilisation bills that will continue, thanks to the decision to use short-term instruments for the earlier mopping up operations.

And the weakness in the dollar has come as a boon for the money market as the RBI has been forced to intervene in the foreign exchange market to hold down the rupee. That has released liquidity into the money markets.

The question is whether this easy liquidity is here to stay. The market has been skittish, with traders worrying whether the government will go ahead with its plan to raise Rs 8,000 crore through bonds early next month.

On the demand side, it's not only government borrowing that is a source of concern; non-food credit offtake has been strong, and the underlying reason for the lack of liquidity with banks is, simply put, the fact that the incremental credit-deposit ratio has been in excess of 100 per cent in recent weeks.

With indications of increased investment in fixed assets by companies, credit offtake can only increase. The mitigating factor could be the renewed appetite by global investors for emerging market assets, which could lead to more external commercial borrowings and tapping of bond markets abroad.

Companies are already taking advantage of this trend to raise resources overseas and, to that extent, they will lower their domestic borrowing requirements. Reports also indicate that small savings collections have improved substantially. If this is sustained, it would reduce the need for the government to borrow from the markets.

On the demand side, the strengthening rupee, boosted by strong FII inflows, has already prompted the RBI to buy dollars""releasing rupee liquidity into the system. If the RBI is unable to achieve full neutralisation""as seems likely""a stronger rupee could dampen inflationary pressures since it makes imports cheaper.

What is important is that the central bank has already made it clear that it has changed its bias towards tightening. Bank deposit and lending rates are moving up. Inflationary pressures continue to be strong, with both oil and commodity prices showing no signs of a decisive retreat.

In the circumstances, the central bank will have to ensure that, while it tightens monetary policy to ensure that long-term interest rates reflect inflationary expectations, short-term rates do not shoot up to cause distress.