- Wealth PMS
At 10PM, way past RBI’s bedtime, there shows up an innocuous press release from the RBI. It has effectively slashed liquidity with (nearly) immediate effect, and in a roundabout way, increased interest rates.
I know, this sounds like gibberish.
To the uninitiated, the RBI allows banks to borrow overnight from it at the “Repo” rate. (Currently this is 7.25%) The amount banks can borrow has been unlimited, as long as it can provide government securities as collateral. The RBI frowns (but doesn’t penalize) when repo borrowing crosses more than 1% of banks’ “Net Demand and Time Liabilities” (NDTL). To get a better idea of what NDTL is, please read Dheeraj’s excellent tutorial on these terms at Capital Mind.
You can think of NDTL as the total amount of deposits (it’s close to that). Currently, the system has about Rs. 75 trillion (75 lakh crore) rupees as NDTL.
Read more about the Marginal Standing Facility (MSF). In short, it’s like the Repo but for extremely desperate borrowing. The MSF Rate was at 1% above the “Repo Rate”. (So, currently 8.25%).
The MSF rate has been hiked to 3% above the repo rate – or 10.25% today.
And then, from Wed July 17, Repo based borrowing has been limited to 75,000 cr. Meaning, if banks want more, they have to go the MSF route. And within the 75,000 cr. limit, each bank will get a “pro-rata” allocation according to the amount they bid.
Finally, the RBI will conduct an OMO – Open Market Operation – by printing rupees to buy some securities to give banks some liquidity. Presumably it has sold dollars and needs to offset that.
RBI will conduct open market sales of Government Securities – effectively, taking rupees from banks and giving them government bonds it holds – which will further reduce liquidity.
(Apologies. I first read that as an Open Market Purchase, a typical OMO)
Liquidity in the system, according to the RBI, is now ample. Banks have recently not borrowed a lot from the RBI. The MSF window has been entirely unused for a while.
Now, if banks do need to use that window, it’s gone. Their marginal rate is now the MSF rate which is 10.25%. This increases their cost when they need liquidity. Effectively in a tight cash situation, banks will have to pay more.
This will mean they will hike their interest rates for lending. Banks always respond quickly to RBI raising their costs, but slowly when the RBI does the reverse.
The RBI balance sheet will contract, and given that I have been advocating this for a while, I applaud the thought behind this. I just wish they didn’t have to do it desperately.
Already, ICICI Bank and HDFC Bank have fallen 1% in the US markets. I believe the bank index will fall tomorrow.
The 10pm announcement reeks of panic. But these steps are okay considering they didn’t impose restrictions on rupee selling or a ban on trading. The aim is to attract capital flows but panic cannot be an option!
Let’s see how the market opens tomorrow.