The dramatic swing from net repo to net reverse repo transaction at the liquidity adjustment facility (LAF) window of RBI needs to be looked into. On July 26, a day before the announcement of the monetary policy review, the net repo volume was Rs 40,980 crore. On July 27, there was a heavy borrowing of Rs 42,465 crore at the first auction before the rate hike. At the second auction of LAF on the same day, there was no repo transaction; instead Rs 3,175 crore was lent to RBI at the reverse repo window. On the day after the event, there was a net reverse repo transaction of Rs 3,520 crore. There was a report that the redemption of government bonds of Rs 32,200 crore on July 28 eased the liquidity position (“Bond redemptions help banks, July 29). But how did the liquidity ease in the afternoon of July 27?
This writer has been arguing all along that, going by the sources and uses of bonds, banks were borrowing at the RBI window to earn arbitrage income. The number of banks borrowing has generally been around 20-25, giving the impression that they are the same ones utilising the window day after day. Of course, the mix could be of different banks on different days. But the advantage to the continuous borrower is the conversion of the overnight facility into a short-term one for all practical purposes. Borrowing from RBI and investing in government securities for a short period can earn tidy profits for them. The rise in the repo rate has obviously eliminated the arbitrage, hence the dramatic demise of the related transaction. But now that the reverse repo rate has gone up by a tidy 50 basis points, we may expect the resumption of the trend of foreign short-term capital inflows and rising reverse repo transactions. With the very low rates of interest prevailing in the Western markets, an arbitrageur can easily make a profit of a minimum of 2 per cent after incurring the transaction and hedging costs. We may expect money markets to move closer to the lower end of the rate corridor. Incidentally, John Taylor of Stanford University has argued in his latest book titled Getting off track that the developed countries attributed the global crisis to a shortage of liquidity rather than to risky assets and interventions that helped the crisis to continue.
A Seshan, on email
