RBI steps in to combat liquidity crisis
Nov 30, 2010

Author: PersonalFN Content & Research Team

In the last couple of months, the capital markets witnessed flooding of new offers in both the equity (in the form of IPOs and FPOs) as well as in the debt (in the form of corporate FD, bonds, NCDS and Long-term Infrastructure Bonds) segment.

But this in turn led to acute liquidity crunch in the system, as post the IPO / FPO closure and allotment, money hasn’t flowed into the system. At present 3-Month CDs (Certificate of Deposits) are trading 8.55% yield, thus leading to situation where the yield on 3-month debt papers and
30 – Yr debt papers are trading at same levels.

And now in order to ease the tight liquidity situation especially in the money market segment, the RBI on late Monday evening (i.e. on November 29, 2010) temporarily decreased the SLR (Statutory Liquid Ratio) to 23% (from actual 25%) fearing a deeper crunch next month on account of advance tax payments.

SLR refers to the quantum (specified in percentage) of securities the banks are supposed to maintain in the form of cash, gold and Government securities.

Thus now banks can reduce their holdings in Government securities by 2% without being penalised for not maintaining the actual SLR of 25%. In other words it also means that banks can now hold only 23% of their Net Demand & Time Liabilities (NDTL) in the form of Government securities; and any level (of SLR) above 23% will entitle them to pledge their securities to raise short-term money.

At present on an average, banks have been borrowing over 1,00,000 crore from RBI through its Liquidity Adjustment Facility (LAF) - as an arrangement to fund the overnight shortfall in cash requirements. And this step taken by the RBI will free 40,000 crore in the system, however it may be inadequate as advance tax payments are due next month.

In our opinion the move taken by the RBI, is prudent as it will reduce the systemic risk caused due to the liquidity crunch. But a noteworthy limitation is that, banks can borrow from RBI as long as they have surplus government securities to offer as collateral.

As an immediate and temporary impact of this we may also see 10 – Yr G-Sec yields softening, which may thus push the price of 10 – Yr G-Secs upwards. As far as policy rates (repo rate and reverse repo rate) are concerned, we don’t expect the central bank raising them in the second quarter review of monetary policy (scheduled on December 16, 2010), as IIP numbers have slowed down (4.4% in September 2010), along with inflation too mellowing down to 8.58% in October 2010 (from earlier 8.62% in September 2010).