Intelligentguess

Overnight Call Money rates rose in the Indian money market today to over 25% p.a. Rates for borrowing against collateral are at a relatively modest 9.5%. Remembering that it was not too long time ago that rates were in their low single digits, that these things can be put in perspective.

While genuine liquidity tightness might be a reason, the pressure on banks to show growth in balance sheet size on the reporting date of March 31 is also contributing to the situation. This is corroborated by the fact that banks are offering juicy rates for short term deposits of 7-15 days (primarily to crossover the financial year end on March 31). Some banks have been rumored to offer rates as high as 20% per annum for some of these short term deposits.

Corporates have pulled money out of liquid mutual funds, a part of which may have been used to take advantage of these relatively high returns. Funds have therefore been forced to look at liquidating short term assets to meet these cash needs. This has in turn led to an increase in yields on short term money market instruments.

Remarkably, bond prices have not fallen much in spite of the tightness. They have actually risen today (more on this subject in a separate post).

The impact of tight money is also being felt in the fx market. The local currency (INR) now trades at 43.10 to the US dollar, a 4 year high. The cash shortage has forced banks to sell dollars. Some arbitrage money may also have found its way from offshore locales accentuating the upward pressure on the local currency.

It appears that the Reserve Bank of India (RBI) has, for the time being, allowed INR to appreciate. A motive for this could be to maintain the pressure on short term rates which would in turn force banks to become less complacent about credit standards. It would also act to retard runaway growth in credit. Relaxation of credit standards and runaway credit growth has been one of the concerns of the central bank. The current bout of silence on market conditions seems to reinforce the fact that RBI is reasonably happy with the current situation.

The liquidity tightening appears to be deliberate (on the part of RBI) and seems to have the blessings of the government too. Government spending would normally ameliorate the situation of cash shortage, something that does not seem to be happening.

Has the central bank moved away from its primary focus of managing exchange rates, and has tilted towards managing money supply / interest rates / credit growth?

My guess is we’ll have to wait some more time to get a clear answer to this question. For the time being though, either endure the pain or enjoy the ride depending on which side of the table you sit on.

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I had recently come across an Economic Times article talking about the large purchases of government bonds that Indian banks had made in recent times (Unfortunately I’m unable to find a link to the URL of the article on the Economic Times website).

Coming at a time of significant debate on the Statutory Liquidity Ratio (SLR) and, how, many banks have holdings that are close to their bare minimum statutory requirement of 25% of deposits, I decided to look at the numbers per se and these are presented below.

These numbers are for the reporting dates mentioned in the first column. The bond (SLR) holding of banks as a percentage of deposits is given in the second column

Date                               SLR holding as % to deposits

01-Sep-06                                                34.13
15-Sep-06                                                33.78
29-Sep-06                                                32.70
13-Oct-06                                                33.32
22-Oct-06                                                33.17
10-Nov-06                                               32.96
24-Nov-06                                               32.83
08-Dec-06                                               32.40
22-Dec-06                                               32.07
05-Jan-07                                               32.16
19-Jan-07                                                31.78
02-Feb-07                                               31.22
16-Feb-07                                                31.47
02-Mar-07                                               32.17

(The figures above are raw and are not adjusted for variations that may arise from daily LAF subscriptions etc. However, that’s not so important for the critical point of discussion in this post)

While there is no doubt that bond holdings (even as a % of deposits) were dwindling from a high of approximately 34% to a low of about 31.25% in early February, the figures seem to convey that the system as a whole has signifcant slack (approximately 7%- based on raw data - as on March 2, 2007) over the minimum statutory requirement of 25%.

If some banks are close to the minimum of 25%, then very clearly there are many who have significant slack - much higher than even 32%. Relative sizes do play a role here. However, if it was only small banks that were holding bonds close to the minimum required, we could not have explained the resilience in bond prices.

Government bond prices have been relatively resilient (rarely has the yield on the 10 year benchmark government bond broken above 8%, in recent times), in spite of the continued monetary tightening resorted to by the central bank. One of the reasons attributed to this has been the relatively small amount of slack available with banks on the SLR front.

Clearly then, there are quite a few large banks who are also flirting with the magic figure of 25%, but even more significantly there are several who hold significantly large holdings (over and above the SLR requirement).

One of the options under consideration has been reduction in the SLR level itself (for which powers have now been granted to the Reserve Bank of India by the Indian Parliament). However RBI may be unwilling to do so at this juncture, given its stance on monetary tightening.

Maybe, usage of “moral suasion” here may be something that could be under contemplation.

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