Liquidity squeeze....Is it a crisis?

Liquidity squeeze not to be seen as crisis

There is serious discussion in the market demanding immediate CRR cut from RBI on LAF drawdown hitting a peak of Rs.1.8 Trillion at start of the current fortnightly reporting cycle. Is this a serious problem to expect an immediate policy action ahead of midterm review on 15^th March? It is definitely not. Let us get into details. Initially, it was RBI’s agenda to maintain system shortfall at 1% of NDTL to maintain operative policy rate at higher end of LAF corridor to arrest demand-push impact on inflation. This worked well till October 2011.

The economy faced serious issues from Euro zone crisis since July 2011. The resultant downtrend in growth momentum (from over 8.5% to below 7%) impacted revenue collection; rupee reversed sharply from a position of strength into weakness and shift of credit demand from foreign currency to rupees. The slippage in fiscal deficit from budgeted 4.6% to projected FY12 actual of above 5.6% has caused additional demand of over Rs.1 Trillion rupees on the system. RBI has absorbed Rs.50-100K Crores from the system to defend rupee. There has been sharp increase in the liquidity spread on foreign currency funding; higher spread over LIBOR and higher cost of conversion (of dollars to rupees) has made dollar funding unattractive to borrowers. The 3-4% arbitrage available till October 2011 on dollar funding has now reversed into 1-2% arbitrage on rupee funding. At current 3M FX premium of 9%, it makes sense for exporters to fund in rupees (at base rate of 10.0-10.5%) at all-in dollar rate of 1.0-1.5%. On the other side, importers have also lost the interest cost advantage of shifting sight imports to dollar denominated Buyers/Suppliers’ credit. There has been sharp run-down in the Foreign Currency Loan portfolio of Banks which are repaid through rupee loans.

RBI has no control over the pressure on the market from fiscal deficit. At this stage, there is no case for RBI to defend rupee by selling dollars. The immediate need therefore is to address the structural issue of releasing the demand on rupee credit by shift to foreign currency. There is availability of dollar liquidity given the extended financial support in the western markets and these funds need to be used to address rupee liquidity owes. RBI has more or less exhausted its OMO option; now over Rs.1 Trillion and has also delivered the first round of CRR cut. It may need to use the FX options with the twin objective of releasing rupee funds into the system and bring the cost advantage on dollar funding. It may need to absorb excess dollar supplies in the spot market and also resort to Buy/Sell swaps in the forward market. The risk factor is on possible trend reversal for rupee which is looking very bullish now for test/break of 48.50. But allowing a correction into 49.50 may not hurt the market stake holders; stability at 48.50-49.50 (at worst within 49-51) post the risk of extended rupee weakness beyond 54 (into 56-58) is considered good.

The system is short (of rupees) by an average Rs.1.25 Trillion (higher drawdown from LAF counter at over Rs.1.5 Trillion at start of reporting cycle and down below Rs.1 Trillion by end of cycle); i.e., by 2% of NDTL. It is expected that CRR will be at 3-4% during the course of FY13 to adjust this shortfall. RBI is now seen in a position to absorb escalated demand from the Government through OMO. The current liquidity strain is seen as temporary. It will go worse by second fortnight of March on advance tax outflows but end-of-the year Government spending and shift into FY13 will release pressure significantly. The expectation therefore is for RBI to infuse liquidity through FX market; continue with 50 bps CRR cut and conduct OMO purchases as and when necessary. The rate action will be delayed till April 2012 Annual monetary policy review with close track on commodity prices and ability to execute fiscal consolidation. The growth factor has become pivot to remove worries on fiscal deficit and its impact on liquidity and rates. RBI may not be keen to support growth at the cost of inflation but there has to be a balanced approach to get into a win-win situation. We stay focussed on liquidity and OIL to get better clarity on the way forward.

Happy reading..............Moses Harding