RBI acting in a jiffy!

Belaying RBI

The rupee has been lamenting in the last few days and so has been everyone affected by it. Rising prices and the falling rupee has combined to make a volatile cocktail, exploding on the common man's face and giving the most nightmarish experience of daily living. Rupee has seen a drastic downward trend in the last couple of months, moving from bad to worse; it saw a life time low to 61.21 against dollar after the better than expected US jobs data raised anticipation of monetary tapering soon. Strengthening of dollar index overseas, strong importers demand, continuous capital outflows coupled with widening current account deficit has put pressure on the rupee. The over 13% depreciation of the rupee from the beginning of April has the markets jittery and the government worried. The sole supplier of money is trying all possible ways trying to save its product. The last month saw various actions by the RBI.

The life time low of rupee prompted immediate action by the RBI to ban all proprietary trading in currency futures and options by authorized dealer banks with immediate effect. While the RBI has barred authorized dealer banks from trading in currency futures and options (F&O) on their own, they will, however, be allowed to trade on behalf of their clients. The central bank also asked oil firms to buy dollars from a single bank to curb bunched up demand. July 15^th however saw major reform actions from the RBI front to prevent the clamp of the rupee from reaching the psychological dread figure of 60.These actions included the following:

      >The central bank restricted banks' borrowing through LAF (liquidity adjustment facility) to 1% of total demand and time deposits or Rs 75,000 crore, whichever is less. LAF is the combination of two auction routes: repo and reverse repo. While banks borrow from repo currently at 7.25 percent, they park their excess liquidity via reverse repo rate at 6.25 percent.

     >MSF (marginal standing facility) rate increased 200 basis points to 10.25% from 8.25%, i.e, 300 basis points higher than the repo rate. It is the rate at which banks can borrow money from the RBI pledging extra SLR bonds (the SLR rate is at present 23%).

      

       >OMO (open market operation) sales of 12,000 cr. on July 18^th.

The open market operation sale of bonds however, remained an unsuccessful paradigm. Much below the objective target, the Reserve Bank of India raised only Rs. 2,532 crore through the open market operation bond sale on 18th July, against the targeted Rs. 12,000 crore. The primary reason for RBI to not accept all bids for sale despite its objective to curb excess liquidity in the system was the uncomfortable nosedive in rates which would hurt investor sentiments adversely.

A Step Ahead

Actions undertaken seemed impotent and rupee still hovered around the 60 mark, more from the RBI end was required to defend the currency, further actions by the RBI on July 23^rd were as follows:

• RBI reduced the liquidity adjustment facility (LAF) for each bank from 1%of the total deposits to 0.5%, thus limiting the access to borrowed funds from the central bank with immediate effect. The earlier imposed cap on overall allocation of funds at Rs 75,000 crore under LAF stands withdrawn. For the system as a whole, 0.5 percent of total deposits mean Rs 37,000 crore.
• RBI has also asked banks to maintain higher average CRR (cash reserve ratio) of 99%of the requirement on daily basis as against earlier 70%. CRR is portion of deposits that banks are required to keep with RBI.
• RBI also capped the total amount of funds available to a standalone Primary Dealer under LAF at 100% of the individual PD's net owned funds as per the latest audited balance sheet.

With all these measures, the central bank will continue to closely monitor the markets, the liquidity situation and the macroeconomic developments. It will take similar measures as necessary, consistent with the growth-inflation dynamics and macroeconomic stability, said RBI, which further announced its first quarter (April-June 2013) monetary policy on July 31, 2013.This monetary review was marked by unchanged key rates as was expected by the markets. The Governor justified RBI’s stance by mentioning that there could have been monetary easing considering decelerating growth and a better inflation numbers but since the primary focus at the moment was exchange rate volatility, a STATUS QUO was preferred.

Were the liquidity curbs effective?

The question that now arises is that whether these measures were effective, and if they were what would have been their consequences:

• The benchmark 10-year bond yield hit a 14-month high of 8.50%, up 33 basis points on the day and 95 basis points since the RBI's first round of measures on July 15.
• The one-year overnight swap rate jumped to 9.30%, it’s highest since September 2008 when the collapse of Lehman Brothers was roiling global markets.
• Short-term debt markets issues, particularly commercial paper with tenors of up to 3 months have surged 200 basis points.
• Following the RBI's second round of measures, the rupee gained 65 paisa to 59.11 in late following day trade at the Interbank Foreign Exchange market.
• Bank stocks got pounded and they took down with them the Nifty and the Sensex. As on July 24^th, Nifty closed 1.44% lower and Sensex closed 1.04% lower, down by 87 and 211 points respectively.

The graphs below clearly show that the last few actions of the RBI have caused the interest rates (both in the government securities market and the swap rate) to rise. Also, as shown in the graphical representation, these liquidity restraining measures have given a bit of relief to the rupee which before these actions was depreciating abominably, but is still far from comfortable or better said affordable range

A typical Yield Curve

An unusual yield curve is seen in the current scenario (blue line in the graph below)-Inverted yield curve, a situation when short-term interest rates are higher than long-term rates. Recent actions by the RBI have surged the short term yields, the 3 month and 6 month yield have risen to 10.8% and 10.2% respectively as on July 25^th 2013. Under unusual circumstances, long-term investors will settle for lower yields now if they think the economy will slow or even decline in the future. An inverted yield curve can indicate an unhealthy economy, marked by high inflation and low levels of confidence.

Debt Mutual Funds Affected

Mutual funds are bracing for a fresh round of redemptions from their fixed income schemes after the liquidity tightening measures to contain excessive speculation in the rupee. Mutual fund officials are expecting outflows from most debt schemes, a category which has seen sizeable inflows in last few months. The mid month liquidity measures of the RBI resulted in the redemption of about Rs. 60000-70000 crore. On July 16^th, Mutual funds faced one of the highest single day outflows since October 2008.The second round of liquidity measures has, however, seen less redemptions (roughly about Rs.25000 Crores) because either a large chunk of outflows from debt schemes had already taken place or that people started believing the RBI measures as a short term phenomenon. Notably, RBI’s special liquidity 3 day window which allows banks to borrow a total of Rs. 25000 crore at 10.25% was not used, reasons cited were that they posited enough liquidity. But the more convincing reason can be that the banks are finding the borrowing cost of 10.25% too high.

So, is it enough?

Apart from the currency problem that is clouting RBI to monetary tightening actions, there’s a continuous pinch from the fiscal arm too. Fiscal deficit occurs when the government spends more than it earns and to fill the gap of budget deficit, one of the measures used by the RBI is sale of bonds. The fiscal target for this year has been 4.8% of the GDP (5050.24 billion rupees), more than 30% (1807 million rupees) of which has already been breached in the first two months. So, a further growth sacrificing and increasing interest rate phenomenon seems in store from the fiscal perspective too.

It is clear from the string of recent measures that the government does not want the currency to be trading meaningfully above 60.The biggest question that now arises is whether these actions are temporary. If the RBI is trying to achieve medium term currency stability then these measures are going to last for a while but if it is just about a shock therapy to cleanse up the system or if they believe that there are speculative positions in the system which will get cleaned up through this measure then it could be a relatively temporary measure and in that sense lending and deposit rates might not go up substantially. Unless a country has a relatively stable exchange rate it is very difficult to convince FDI’s and FII’s to invest in India. It can be concluded that these measures have been the ventilator and unless structural recovery takes place, it will be difficult for the financial life in the form of investor confidence to sustain.