A short-term liquidity crunch in the banking system pushed the overnight inter-bank call money market rates to 80% on Wednesday, the highest since 1996 when the overnight call rate topped 100%.
As fund-starved foreign banks rushed to sell dollars in the foreign exchange market to generate rupee liquidity, the dollar weakened against the local currency for the second consecutive day. Riding an over-supply of the greenback, the rupee strengthened to 43.44 per dollar, a 19-month high. With this, the currency has risen close to 1.4% in two days.
Meanwhile, some banks used the opportunity to good effect, arbitraging between Reserve Bank of India funds (which they borrowed at a lower rate) and call money (which they loaned out at higher rates). The sudden liquidity crunch follows an estimated Rs40,000 crore advance tax outflows from the banking system last week.
Indian corporations pay advance corporate tax every quarter of a financial year. “The liquidity in the system always tightens at the end of every quarter following the advance tax outflow but the tightness has been intensified this time with the RBI actively sucking out money through various measures,” said a primary dealer who sells government bonds.
The central bank has done this to fight inflation by regulating money supply. It raised banks’ cash reserve ratio by 1% between December 2006 and now, removing over Rs50,000 crore from the system. Besides, it has also been holding regulator auctions under a special scheme to drain money.
Some commercial banks used the tightness in liquidity to their advantage by arbitraging between RBI’s repo window from which they borrow, and the inter-bank market.
Banks can borrow from the central bank by pledging their surplus government bond holdings with it. Those banks which have surplus government bonds, borrowed from RBI at rates beginning at 7.5%, lent the money at the inter-bank market at 60%-80%. A late evening RBI release said banks should not raise money from the repo window to lend to borrowers but can use the fund for lending in the inter-bank market.
Banks borrowed Rs34,055 crore from RBI on Wednesday. The amount was Rs35,250 crore on Tuesday.
Senior bankers attribute three reasons to the sudden spike in the call money market. First, not too many banks have surplus securities that can be pledged with RBI for raising money from the central bank. Banks are required to invest at least 25% of their deposits in government bonds. Till last year, they used to hold a much larger bond portfolio but with the corporate appetite for loans growing, most of them have liquidated their bond portfolio to support the loan growth.
Secondly, banks’ exposure to the call money market is capped and no bank can lend an amount higher than its capital in this market. The supply of resources has been further tightened following the ban on insurance firms and mutual funds in the call money market. These players could earlier lend in this market even though they were not allowed to borrow. They have been banned from this market since the banking regulator wants to develop the call money market as pure inter-bank play.
“The rupee is appreciating against the dollar as traders are compelled to convert dollars into local currency. In the morning, there was some support and the rupee went up to 43.75 as market participants were expecting RBI to step in and buy dollars from the market, but there was no intervention at all,” said Sandeep Bhandari, head, global markets, South Asia,Standard Chartered Bank.
Money market dealers say once the government starts spending in the new financial year beginning April, the liquidity tightness will ease. “There is a severe cash shortage in the system. We need to wait till the government starts spending. I do not see any other short-term triggers that can change the market sentiment ” said Ashish Parthasarthy, head, trading at HDFC Bank.
Bankers also feel that trade unions calling off the three-day industry-wide strike, slated to begin on 28 March, will ease the pressure on liquidity. Public sector banks have been borrowing heavily over the past two days, in the run up to the strike.
“Banks were covering in advance for three trading sessions and running to the call market to meet the cash reserve requirements. Now that the strike has been called off, we expect call rates to come crashing down in a trading session or two,” saidD. Suresh Pai, chief dealer treasury at Canara Bank.