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While RBI's liquidity framework entails managing weighted average overnight rate, there appears to be an implicit element of 'tough love' at play. This is evidenced by somewhat reluctant use of liquidity infusion tools despite the anchor having moved to MSF rate for an extended period of time (14 day VRR was announced last week). Also the argument couldn't have been around the risk of 'overdoing' it since the variable repo is a temporary and voluntary tool. Thus offtake here is need based and, if overnight rates fall too much, RBI can choose not to renew it.The ReliefMarket participants have been justifiably wary of the liquidity environment over the past month. However, as shown above, core liquidity had already started to turn substantially. This is now expected to get an additional fillip for the following reasons:As per seasonality, the phase of CIC rise is over for now. From now till end September there is actually a degrowth in CIC to some extent, and then it picks up again with the start of the so-called busy season from October.The RBI surplus transfer will add to liquidity. Since it comes on the heels of large government bond maturities of approximately Rs 1 lakh crore, it will likely not get locked up as surplus cash balances (government surplus will deplete on payment of bond maturities and then get replenished with RBI transfer, all other things remaining constant).The withdrawal of Rs 2000 denomination notes will work largely through two channels: One, a large portion of this will likely get exchanged into other denominations. Thus there is no liquidity impact for this portion. Two, some portions will get deposited into banks. This component will directly reduce CIC and increase banking system liquidity. It is as yet quite unclear what this amount is likely to be. However, assuming a 20 - 30 per cent conversion rate into deposits, system liquidity should eventually go up by Rs 0.7 - 1.1 lakh crore, ceteris paribus.ImplicationsIt is likely that as system liquidity improves, the overnight secured rate starts to hover between SDF and repo, rather than the MSF rate at which it has been stubbornly stuck over most of the past month. This has already been happening for the past few days. Furthermore, based on the factors analyzed above, and unless there is a large draw forthcoming on forex reserves, the market will be comfortable expecting the overnight rate to remain in the SDF - repo band for the next few months. Combined with the view that the policy rate cycle has peaked, this should lead to stronger demand for the front end of the curve. This should manifest in incremental steepening of the curve, especially given the aggressive flattening that has happened recently. Our preference remains for 3 - 6 year maturities on the yield curve and we expect these to do well relatively in light of these new developments as analyzed above. Demand for quality money market instruments should also turn robust with funding rate becoming more stable.While the higher surplus transfer is also incrementally positive for the fiscal, there are still pressures lined up ahead on this count. For one, the fertilizer subsidy bill may be higher than budgeted by Rs 46,000 crore as per media reports. Also importantly, the nominal growth assumption in the Budget is likely to get undershot in our view given our more conservative assessment of growth for the year ahead. This will put some pressure on budgeted revenues.(Suyash Choudhary is Head -Fixed Income at Bandhan Asset Management)
--IANS suyash/dpb
(Disclaimer: This post has been auto published from IANS news agency without any modification to the text and has not been reviewed by editor)
