Embed Size (px)
Citation preview
Liquidity ManagementA regime change by RBI
Liquidity Management – A regime change by RBI
The RBI released its first monetary policy statement for the FY 2016-17 on April 5. The key highlights of the policy were:
Repo rate was cut by 25 bps from 6.75% to 6.5%
RBI has decided to progressively migrate system liquidity target from a deficit of 1% of NDTL to a position closer to neutrality
Policy rate corridor was narrowed from +/- 100 bps to +/- 50 bps by adjusting MSF and Reverse Repo rates
The RBI also signalled that the policy will remain accommodative. The rate cut was widely expected. With this rate cut the cumulative easing in this cycle has reached 150 bps. We believe that we are approaching the end of the easing cycle with large further policy rate cuts unlikely.
However even as the scope for fall in policy rates may be limited, there is reasonable scope for market yields to fall especially given the liquidity measures announced. We think that the suggested changes in liquidity management are transformational in terms of their likely impact on the yield curve.
•
•
•
Rates at the short end of the yield curve are impacted by liquidity and RBI’s rate actions. Increase in liquidity results in easing of rates, as banks have higher deployable surpluses, thereby reducing pressure on raising deposits. Decrease in liquidity has the opposite effect. This is in addition to the impact on account of RBI’s rate actions.
RBI has taken a number of steps in the last year to bring down volatility in overnight rates. While the extreme volatility has indeed come down, normal swings in overnight rates do take place as a response to the changes in liquidity conditions. Further, while the immediate effect of liquidity on rates tends to be on the overnight rates, any sustained change tends to flow through to the rest of the money market curve.
In order to understand the significance of the move, let us look at the background of liquidity management and its impact on market yields
Liquidity Management – A regime change by RBI
LIQUIDITY AND RATES
Liquidity refers to the available money supply within the monetary system. Net system liquidity can be in a shortfall/deficit or surplus depending on certain short term and structural conditions of the economy. The central bank manages the system liquidity by removing surplus liquidity or providing liquidity in case of a deficit. The tools to manage liquidity could be structural (provide/take away long term liquidity) or short term (manage temporary liquidity conditions).
The drivers of liquidity include demand for currency (which reflects behaviour of households), demand for excess reserves (which reflects behaviour of the banking system), the central government’s balances with the RBI (which depend on the cash flows of the government) and forex market intervention by the RBI (which depends on foreign flows and currency volatility).
Further, in order to support the growth rate prevailing in the economy and depending on the velocity of money, there is a required rate at which base money needs to grow. RBI liquidity management operations also need to take this into account.
Temporary liquidity management tools used by the RBI:
• LAF (Repo, MSF, reverse repo), Term repos and any other standing windows
Structural Liquidity management tools used by the RBI:
• Open market sales/purchases operations (OMO, CMB, MSS)
• Foreign Exchange operations (buying /selling of FX to reduce currency volatility)
• Changes in banking system cash reserve ratio (CRR)
WHAT IS LIQUIDITY?
Over the last couple of years, the RBI has gotten better at managing temporary liquidity needs of the system (thereby bringing down the volatility of the Weighted Average Call Rate). The focus of liquidity management has moved away from the standing facilities to market operations (term repo/reverse repo auctions etc). Given that it now has confidence that its variable rate tools allow it to manage short term system liquidity without the system hitting the reverse repo level, it no longer feels compelled to keep the system in significant average liquidity deficit. Additionally it has allowed the RBI to narrow the policy rate corridor.
However even though it has managed the short term liquidity successfully, it has been neglecting the longer term/structural liquidity challenges facing the economy. The significance of the monetary policy lays in the acknowledgement of this problem by the RBI as well as by their recommended solution for the same:
“Experience suggests that the provision of short term liquidity does not substitute fully for needed durable liquidity, though durable liquidity can substitute for short term liquidity needs. Going forward, the Reserve Bank intends to first meet requirements of durable liquidity, and then use its fine-tuning operations to make short term liquidity conditions consistent with the intended policy stance.”
In other words, the RBI is accepting the fact that it needs to first and foremost target structural liquidity in the system before adjusting for the short term liquidity environment.
CHANGES IN LIQUIDITY MANAGEMENT ANNOUNCED IN THE MONETARY POLICY
2
Liquidity Management – A regime change by RBI
3
As mentioned earlier, adjusting for other factors, it is generally seen that tightening liquidity tends to produce higher rates across the money market curve and vice versa. Provided below are illustrations of cases where system liquidity went through a large change and the reaction of the 1 year CD spreads to the same.
SYSTEM LIQUIDITY AND MARKETS RATES
The relation between liquidity and rates is thus quite evident. Hence it is expected that as system liquidity goes from the current large deficit situation to neutral it should help bring down yields.
Further, it is also to be noted that liquidity, as indicated by LAF balances (refer Chart below) has been in deficit mode for most of the last 5 years.
System Liquidity and 12 Mo CD Spread over Repo (Feb '10-Dec '10)
L.H.S. 30-day rolling average Liquidity
R.H.S - Spread over repo
Sp
read
Syst
em
Su
rplu
s (i
n c
rore
s)
System Liquidity and 12 Mo CD Spread over Repo (Jan '11- May '11)
L.H.S. 30-day rolling average Liquidity
R.H.S - Spread over repo
Sp
read
Syst
em
Su
rplu
s (i
n c
rore
s)
System Liquidity and 12 Mo CD Spread over Repo (Mar-12 to Sep-12)
L.H.S. 30-day rolling average Liquidity
R.H.S - Spread over repo
Sp
read
Syst
em
Su
rplu
s (i
n c
rore
s)
System Liquidity and 12 Mo CD Spread over Repo
L.H.S. 30-day rolling average Liquidity
R.H.S - Spread over repo
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
(250,000)
(200,000)
(150,000)
(100,000)
(50,000)
-
50,000
100,000
150,000
200,000
Feb
-10
Mar-
10
Ap
r-10
May-
10
Jun
-10
Jul-
10
Au
g-1
0
Sep
-10
Oct
-10
Nov-1
0
Dec-
10
Sp
read
Syst
em
Su
rplu
s (i
n c
rore
s)
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
(250,000)
(200,000)
(150,000)
(100,000)
(50,000)
-
50,000
Mar-
12
Mar-
12
Ap
r-12
May-
12
May-
12
Jun
-12
Jul-
12
Jul-
12
Au
g-1
2
Sep
-12
Sep
-12
0.00%
0.50%
1.00%
1.50%
2.00%
(250,000)
(200,000)
(150,000)
(100,000)
(50,000)
-
50,000
Jan
-14
Feb
-14
Mar-
14
Ap
r-14
May-
14
Jun
-14
Jul-
14
Au
g-1
4
Sep
-14
Oct
-14
Nov-1
4
2.00%
2.20%
2.40%
2.60%
2.80%
3.00%
3.20%
3.40%
3.60%
3.80%
(250,000)
(200,000)
(150,000)
(100,000)
(50,000)
-
50,000
100,000
150,000
200,000
Jan
-11
Jan
-11
Jan
-11
Feb
-11
Feb
-11
Mar-
11
Mar-
11
Ap
r-11
Ap
r-11
May-
11
May-
11
Liquidity Management – A regime change by RBI
Statutory Details and Risk Factors
Statutory Details: Axis Mutual Fund has been established as a Trust under the Indian Trusts Act, 1882, sponsored by Axis Bank Ltd. (liability restricted to ` 1 Lakh). Trustee: Axis Mutual Fund Trustee Ltd. Investment Manager: Axis Asset Management Co. Ltd. (the AMC) Risk Factors: Axis Bank Limited is not liable or responsible for any loss or shortfall resulting from the operation of the scheme.
This document represents the views of Axis Asset Management Co. Ltd. and must not be taken as the basis for an investment decision. Neither Axis Mutual Fund, Axis Mutual Fund Trustee Limited nor Axis Asset Management Company Limited, its Directors or associates shall be liable for any damages including lost revenue or lost profits that may arise from the use of the information contained herein. No representation or warranty is made as to the accuracy, completeness or fairness of the information and opinions contained herein. The material is prepared for general communication and should not be treated as research report. The data used in this material is obtained by Axis AMC from the sources which it considers reliable.
While utmost care has been exercised while preparing this document, Axis AMC does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Investors are requested to consult their financial, tax and other advisors before taking any investment decision(s). The AMC reserves the right to make modifications and alterations to this statement as may be required from time to time.
Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
The constant structural liquidity deficit has caused uncertainty in pricing the term premium. The uncertainty causes the yield curve to be steeper than it would otherwise be. The expected transition by the RBI to a neutral liquidity position has the potential to reduce uncertainty in the money market and bring down term premiums and hence flatten the curve.
Combining these two effects, we believe that the measures announced in the monetary policy can lead to a substantial fall in market yields over 6-12 months as these steps get implemented and their implications become clear.
Data as on 5th April 2016. Source: Bloomberg
(200,000)
(150,000)
(100,000)
(50,000)
-
50,000
100,000
150,000
200,000
Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16
System Liquidity (Surplus/Deficit)
30-day rolling average
