Friday, April 4, 2014

India's Interest Rates Experiment

India's ten-year government bond yield jumped to a four-month high on Thursday ahead of the first bond auction for the fiscal year and the new liquidity measures. The last debt auction was conducted back in February, with the resumption of the issuances widely-expected to exert some upward pressure on the longer-term bond yields.

The Reserve Bank of India (RBI) adopted certain liquidity-related proposals from the Urjit Patel’s committee at this week’s review. These changes were an attempt to lower the banks’ passive dependence on overnight liquidity for cash/treasury requirements. More refinements are likely in this space in coming months. The Patel committee had also recommended phasing out of the export refinance credit facility and shifting the operating target to the 14-day term repo rate. Additionally, it was also stressed that the MSF (marginal standing facility) rate should be made a "truly penal rate", which the banks can only access during exceptional circumstances.
In fact, in a bid to contain rupee volatility, the RBI had raised the MSF rate by 300 basis points back in July, while capping liquidity adjustment facility borrowings. However, instead of curbing volatility, this measure depressed the currency further and sharply raised borrowing costs in the interbank market. The impact was also severe due to the absence of the term repo market between the overnight window and the MSF. Subsequently, the mismatch has since been ironed out as the MSF rate was lowered to 9% by October and term borrowings initiated with the seven-day and 14-day tenors.
In the immediate-term, while the March spurt has passed, liquidity is likely to remain in deficit mode. Government cash balances with the RBI, which were also seasonally strong in March, and advance tax pay-outs had contributed to the deficit.
But these should begin to ease off into the new fiscal year. The central bank had also stressed that open market operations (OMOs) will be used sparingly, given their unintended impact of capping bond yields. Instead, term repos will be tapped more actively for liquidity management, as was made apparent in the March quarter.