System liquidity has improved significantly over the past few days. As at end of last reporting fortnight (14th June), the system liquidity deficit had slipped to less than INR 60,000 crores; well under the 1% NDTL comfort zone of the RBI. While there is some near term deterioration due to advance tax outflows, liquidity is expected to improve even further towards early July once advance tax returns to the system as government spending. There are two reasons for this expectation:
1. The biggest driver for liquidity since the start of the financial year has been a sharp pick up in government spending. As at last data, the government’s surplus with RBI had practically vanished on account of aggressive spending. This surplus had averaged almost INR 90,000 crores between Jan – March of the current year; thereby frustrating RBI’s liquidity efforts and triggering OMOs. Given the finance minister’s repeated assurances that government will not curtail spending this year, it is likely that the government does not rebuild any significant positive cash balance with the RBI in the time ahead. This may be especially true for the near term as the government is also in the process of paying INR 45,000 crores of last year’s oil subsidy to oil marketing companies.
2. There are seasonal paybacks from currency in circulation between now and September to the extent of INR 30,000 crores that adds to system liquidity. After September this effect reverses, and there is draw-down from the system of approximately INR 90,000 – 1,00,000 crores over October and March.
Interpretation As the liquidity deficit narrows further, it is likely that it leads to speculation that better liquidity is here to stay and is consistent with RBI’s efforts to improve transmission on monetary policy. Indeed, as we have noted before, there are sections of the market who are calling for RBI to engineer a positive liquidity scenario in order to better monetary policy transmission. We have also noted before the difficulties of doing so on a sustained basis (refer “Can aggressive monetary easing create a funding problem in India”, dated 29th May for further details). It is imperative to note that the current improvement in liquidity is owing to heightened government spending and seasonal reversals in currency in circulation and not due to any design by the RBI. The RBI’s laying off OMOs and CRR cuts more than adequately demonstrates this point. Also, the improvement in liquidity will be temporary and will likely reverse from September. Of course, in this whole discussion the RBI’s forex operations is a wildcard. Should the RBI be forced to intervene aggressively to defend the rupee, then the anticipated easing of liquidity may get muted. Market Implication All things equal, this phenomenon should lead to incremental steepening of the yield curve. Better liquidity will provide more incentive to buy front end rates. Whereas absence of OMOs may focus market attention on supply pressures for the long end (net supply of government bonds till August end is more than INR 150,000 crores). However, an important caveat here will be with respect to the rupee. Should the broad global anxiety remain and led to continued rupee pressures, it may negatively impact all parts of the yield curve. Investors should continue to match risk appetite and investment horizons with product selection.
1. The biggest driver for liquidity since the start of the financial year has been a sharp pick up in government spending. As at last data, the government’s surplus with RBI had practically vanished on account of aggressive spending. This surplus had averaged almost INR 90,000 crores between Jan – March of the current year; thereby frustrating RBI’s liquidity efforts and triggering OMOs. Given the finance minister’s repeated assurances that government will not curtail spending this year, it is likely that the government does not rebuild any significant positive cash balance with the RBI in the time ahead. This may be especially true for the near term as the government is also in the process of paying INR 45,000 crores of last year’s oil subsidy to oil marketing companies.
2. There are seasonal paybacks from currency in circulation between now and September to the extent of INR 30,000 crores that adds to system liquidity. After September this effect reverses, and there is draw-down from the system of approximately INR 90,000 – 1,00,000 crores over October and March.
Interpretation As the liquidity deficit narrows further, it is likely that it leads to speculation that better liquidity is here to stay and is consistent with RBI’s efforts to improve transmission on monetary policy. Indeed, as we have noted before, there are sections of the market who are calling for RBI to engineer a positive liquidity scenario in order to better monetary policy transmission. We have also noted before the difficulties of doing so on a sustained basis (refer “Can aggressive monetary easing create a funding problem in India”, dated 29th May for further details). It is imperative to note that the current improvement in liquidity is owing to heightened government spending and seasonal reversals in currency in circulation and not due to any design by the RBI. The RBI’s laying off OMOs and CRR cuts more than adequately demonstrates this point. Also, the improvement in liquidity will be temporary and will likely reverse from September. Of course, in this whole discussion the RBI’s forex operations is a wildcard. Should the RBI be forced to intervene aggressively to defend the rupee, then the anticipated easing of liquidity may get muted. Market Implication All things equal, this phenomenon should lead to incremental steepening of the yield curve. Better liquidity will provide more incentive to buy front end rates. Whereas absence of OMOs may focus market attention on supply pressures for the long end (net supply of government bonds till August end is more than INR 150,000 crores). However, an important caveat here will be with respect to the rupee. Should the broad global anxiety remain and led to continued rupee pressures, it may negatively impact all parts of the yield curve. Investors should continue to match risk appetite and investment horizons with product selection.
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