Curious developments in money markets: Economic Times: 15th Febuary 2012

The liquidity situation in the market is quite bizarre to say the least. The final number that comes out from this market is the net borrowing from the RBI through the repo window. This has been high at over Rs 1 lakh crore on a daily average basis, which is well over the comfort limit of the RBI that has so far maintained that 1% of deposits, which is aroundRs 60,000 crore, is the bearable amount.
When it remains consistently above this mark, then there is reason to worry. More so, because, we have also heard that the corporate sector is not really borrowing these days as the last two fortnights have witnessed a decline in credit. This time, however, there is a slowdown in growth in deposits, too, meaning people are saving less, ostensibly due to higher inflation, which is causing a squeeze on the supply-side for banks. It should actually not be a concern since growth in credit, too, is tardy with high interest rates deterring investment in general. Where then are the funds going?

Funds are actually being channeled into government paper and the investment-deposit ratio is currently 29%. Last year, one may recollect that the RBI had voiced a view that it feared that funds were being borrowed from the repo window and deployed in commercial lending, which could create severe destabilising of asset-liability mismatches.

Here, too, one is borrowing for one day and probably investing in a tenyear paper. But when it comes to investments, it does not matter since they can be sold anytime and tenure matches do not really matter. Therefore, things are not really amiss here. The curious development is how GSec yields have been behaving.

The 10-year G-Sec yields have come to a level of 8.15-8.30%, with average daily repo borrowings of over Rs 1 lakh crore. In November, the rate went towards the 9% mark with such equivalent amounts. Thus, the conundrum really is as to how come the rates have come down in an era of stringent liquidity and unchanged policy rates. One conjecture is that when liquidity crunch is due to the government and not commercial borrowings, then rates do not move in a rational manner because once funds move into G-Secs, then the true cost of funds get blurred.

The other action of the RBI that is taking place relates to OMOs, which is simultaneously infusing longterm liquidity even while funds are being drawn out through auctions of fresh paper. The announcement of OMOs and the expectations of further OMOs on its own has the power to keep rates down, which could be a strong factor working in making it self-fulfilling. Under normal circumstances, rates should be rising given the borrowing programme that has to be completed, which actually should drive down the price of government paper and correspondingly increase the yields.

But that is not happening. The RBI has already supplied over Rs 85,000 crore into the system in this form, which indicates that in case it had not done so, then repo borrowings would have touched the Rs 2-lakh-crore mark. Movements in corporate bond spreads in this market are no less puzzling.

The spread of a triple A-rated corporate is still ruling at just about 100 bps for a 10-year tenure, while the same for say commercial paper vis-avis 364 days treasury bills is above 200 bps. Clearly, there is greater premium on short term compared to long term. And this difference has been maintained across the CP-TBill yields in the 150-200 range bps.

Quite clearly, the financial markets have gone into a spin with theoretical axioms not really holding most of the time. The round tripping of funds through higher borrowings supported by bank investments, which is being supported by OMOs and repo borrowing, has grown to significant levels, which has made interest rates move away from the fundamentals. Given that government borrowing is still uncertain; such volatility may be expected for the rest of this financial year.

To the final question, how will yields move, one really does not have an answer. In fact, the correlation between repo borrowings and 10-year yield since October 1 is just around 50%, and statistically goes with a negative coefficient ie: higher borrowings leads to lower yields -which is not what the text book would say.