Wednesday, January 15, 2014

India's Liquidity Improves

Domestic Indian rupee and US dollar liquidity has shown clear signs of improvement over the past few months and this has clearly manifested in the form of a stronger rupee and lower overnight index swap (OIS) rates. Much of this is due to the narrowing of the trade deficit as imports of precious metals fell.
However, for a more sustainable improvement in external funding to occur, external demand needs to return and translate into better exports. Based on past trends, banking system stress materialises only when the current account deficit exceeds around 3.5% of GDP. This has been reflected in the amount of liquidity the Reserve Bank of India (RBI) has needed to release into the financial system. Notably, liquidity injections only became elevated in mid-2010 and that was the point when the current account deficit widened sharply toward 4% of GDP. Since mid-2013 however, the total amount of liquidity provision (calculated as the repurchase rate, the term repo and the marginal standing facility) has fallen. Moreover, the overnight interbank rate is now hovering between the MSF rate and the repo rate (as opposed to hugging the MSF rate when liquidity was in short supply).
In the short-term, there is scope for front-end rupee OIS rates to head lower as risk premiums become more compressed. However, for this trend to continue to the medium term, a recovery in the trade balance via exports would be needed.