Liquidity dries up on RBI’s sterilisation drive, govt cash balances

Liquidity in the system is slowly drying up as the Reserve Bank of India (RBI) pursues an aggressive sterilisation exercise at a time the government has built up huge cash balance, owing to the goods and services tax collection, while holding back the input tax credit benefit.

Short-term rates have started inching up, because of the tightness in liquidity. Longer tenure rates have risen about 50 basis points in the past three months, following ~90,000 crore of secondary market bond sales by the central bank. In addition, the RBI has also sold about ~1 lakh crore of bonds in four tranches under the market stabilisation scheme (MSS) to mop up excess liquidity.

There are two concepts of liquidity — optical and core. Optical liquidity is the net amount of bank borrowing from and parking of excess liquidity with the RBI, or net of repo and reverse repo operations under RBI’s liquidity adjustment facility. Core liquidity is calculated adding back the government cash balances meant for auction. Most of the time, the auction amount matches the term repo amount, and if there is any excess requirement, the RBI provides for it.

Core liquidity is considered system liquidity for all practical purposes. As on Monday, optical liquidity was at about ~29,000 crore, while system liquidity (including government cash balance for auction) was at ~79,000 crore.

The government’s cash balance with the central bank stood at ~4.4 lakh crore as on November 24. According to Ananth Narayan, a senior bond market expert, rising currency in circulation and RBI’s secondary market bond sales are responsible for drying up of the liquidity.

“The liquidity is fast drying up. Advance tax outflow may also make it zero,” Ananth Narayan said.

Nevertheless, the liquidity situation is a far cry from ~6 lakh crore of excess liquidity after demonetisation, and the RBI had to mop the surplus. But, by buying bonds from the secondary market, the central bank has already hardened the yield and now with liquidity getting drained out rapidly, short-term rates have also risen by 12-15 basis points in the last one month.

The yields on the 10-year bond closed at 7.03 per cent on Tuesday, while the three-month treasury bill closed at 6.12 per cent.

Many in the market expects the 10-year yields to rise up to 7.15 per cent level. But a senior official with a primary dealer (underwriter of government bonds) said the present level of yields could be the peak, as the government would start spending from its cash balances soon.

The central bank’s target now is to keep overnight rates around policy repo rate (currently at 6 per cent), and the central bank would infuse or remove as much liquidity as required to maintain this rate. This is a subtle change in policy because earlier, the central bank used liquidity as a tool to manage overnight rates. Now, the rates are firmly anchored, while liquidity is flexible.

But, hardening of yields is a policy challenge for the central bank, as transmission of rates by banks, something that the RBI has been advocating for long, gets hampered. Besides, a possible rate cut on December 5-6 policy would also likely get negated by rising yields.

Having said that, the liquidity will come back into the system eventually. By March, the MSS bonds would mature and government would be buying back ~30,000 crore of bonds on Wednesday to infuse immediate liquidity in the system. After factoring in the buybacks, bonds maturing between January and April would be ~1.29 lakh crore. It is the immediate shortage of liquidity that the bond market is concerned about.

The spike in rates makes it costly for private enterprises to come to the market to raise money too.

“Indian yield curve is now largely following the global pattern of flattening yield curve. While this will discourage too much reliance on short-term borrowing by financial entities, it also pushes up shortterm cost of borrowing for corporates with legitimate requirements,” said Souymajit Niyogi, associate director at India Ratings and Research. State Bank of India group economist Soumya Kanti Ghosh wrote in a research report that the rising yield could be because “select players” in the bond market were in a selling mode. “Interestingly, after the rating upgrade, some of the market players bought securities and now they are offloading them in the market, driving up yields,” Ghosh said. According to SBI estimates, the increase in yields could cost the exchequer around ~3,200 crore on an annualised basis.