We had recently discussed constraints (US exceptionalism, chiefly) and the need for their optimization (especially given the cumulative output gap still to be filled since the pandemic). The past few months saw an aggressive forex defense and the consequent rupee liquidity impact largely not getting replenished. This was perhaps constraints not being fully optimized given that it led to a more than desired tightening of the banking system and possibly constituted an additional drag on growth. However, the process of rectification has begun and we had mentioned four expectations from macro-policy given the current set-up (https://bandhanmutual.com/article/20475).
The first of these has been in evidence over the past few days with RBI demonstrating more flexibility on the exchange rate and with emphasis on forward forex operations apparently back in play. More to our immediate interest, however, the central bank has now started on the second point: more proactive provisioning of liquidity. In this context, yesterday’s announcement that RBI will henceforth conduct overnight variable rate repo (VRR) operations is very welcome. The following points are relevant, in our view:
1. Core system liquidity has turned negative in our estimate, thereby offsetting the full impact of the December CRR cut and with the season of pick- up in currency in circulation upon us. Additionally, even with some shift in forex approach, further outright interventions in the spot market cannot be ruled out which will constitute an additional drain on liquidity.
2. Thus, the daily overnight VRR operation announced yesterday should be looked at as the first urgent measure to stabilize the system while the RBI contemplates the choice, quantum, and sequencing of measures for permanent liquidity infusion. To be clear, VRR operations cannot substitute for the need for permanent liquidity even as they are critical for now to stabilize the overnight rate and assure market participants that daily liquidity is readily available.
3. From a market standpoint, the immediate impact is the stabilization in overnight rates and therefore the first beneficiary are front end SLR assets that are self-funded (can be pledged to borrow money against).
4. To the extent that the market takes this as a strong signal that the RBI has now swung into action and reads this (as we do) as the precursor to imminent steps on adequate permanent liquidity measures, some relief may start to percolate to the front end of the non -SLR curve as well (bank CDs and 1 – 2 year corporate bonds).
5. However, given the rapid deterioration in core liquidity time remains of the essence on permanent steps, more so as we approach peak ‘busy’ season. Should RBI for whatever reasons delay further steps (not our base case at all), then pressure on front end non-SLR rates will continue.
6. Liquidity provisioning is the need of the hour and matters much more for both the lending system and market rates, than a rate cut at this juncture. To clarify, however, our portfolios are positioned for rates to fall and to that extent we will welcome a rate cut in February. That said, in our assessment, what matters more for rates falling at this juncture is infusion of permanent liquidity rather than a rate cut.
7. Whether or not a rate cut happens in February may depend upon the MPC’s assessment of degrees of freedom available given the global context. While there has been some relief on this aspect very recently, the new US government is about to come in and one may have a flurry of announcements soon after that may have a bearing on dollar and US rates.
8. While repo rate is only modestly tight and movement here can be basis some let up in global financial conditions, we reiterate the obvious point that meaningful steps on permanent liquidity infusion cannot be delayed. Consequently, investors may also be able to take this leap of faith when assessing incremental opportunities. A slightly elongated time horizon on investments can be the offset for near term potential volatility.
Source – Bandhan Internal research
16 January 2025
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