RBI's liquidity deficit denial spells higher yields

By Abhishek Gupta (Economist)

The Reserve Bank of India has signaled it's unlikely to give much clarity on bond purchases that could replace a short-term liquidity deficit with durable liquidity. The deficit is one reason why there's so much upward pressure on bond yields. In our view, the RBI's refusal to acknowledge the durable liquidity shortfall in the economy, along with another measure aimed at reducing banks' regulatory demand for government bonds, is likely to push sovereign bond yields higher.

The RBI said in a statement on Thursday that banking system liquidity is in ample surplus. What the central bank is calling an ample surplus is, in fact, a temporary infusion of liquidity -- which itself is a measure of the liquidity deficit in the banking system.

Bloomberg Economics' daily index of banking system liquidity shows a deficit of 734 billion rupees. This reflects the banking system's net borrowing from the RBI, with a short- term maturity of less than a month.

• The RBI said it has provided ample short-term liquidity. That is the case. But its claim that this infusion is resulting in an ample liquidity surplus is off the mark. The failure to acknowledge the durable liquidity deficit suggests the RBI is unlikely to give much clarity on how it might conduct bond purchases. In our view, it needs to step up bond purchases to meet growing durable liquidity needs of the economy.
• The RBI since April has conducted bond purchases of 400 billion rupees and announced another 100 billion rupees for Sept. 27. This infusion of durable liquidity by the RBI has been more than offset by an estimated 1,300 billion rupees of liquidity removal via FX sales. In addition, a regular infusion of durable liquidity needed to finance a growing economy hasn't been forthcoming from the RBI.
• The RBI's ambiguous position on liquidity conditions is likely to increase the risk premium on sovereign bond yields, in our view.

India's Banking System Liquidity in Durable Deficit

In another measure to address the liquidity shortage announced on Thursday, the RBI lowered its regulatory requirement for banks' holdings of sovereign bonds by roughly 2% of aggregate deposits, or 2.4 trillion rupees. To understand this regulatory change, we need to go through the technical details of the regulatory landscape of banks' demand for government bonds. Indian banks demand government bonds to meet two kinds of regulatory requirements:

• The statutory liquidity requirement, which is prescribed at 19.5% of net demand and time liabilities, or, roughly, aggregate deposits.
• The liquidity coverage ratio under Basel III norms, which is defined in terms of high-quality liquid assets. We estimated this to equal roughly 19-20% of aggregate deposits.
• Any statutory liquidity reserves held over 19.5% of aggregate deposits, needs to be marked to market.

Banks mostly meet these liquidity requirements by holding government bonds. As part of existing regulations, banks were allowed an overlap equal to 13% of aggregate deposits to meet both these requirements. The latest change relaxes that to 15%, effectively reducing banks' regulatory demand for government bonds by 2% of aggregate deposits to 24% of aggregate deposits.

The RBI undertook a similar relaxation from 11% to 13% in June, which as we had argued has pushed bond yields higher. In theory, this liquidity requirement relaxation should be seen as a positive for banks as it will help certain banks meet their liquidity coverage ratio, while others can sell excess government bonds in exchange for much-needed rupee liquidity. In practice though, this is unlikely to be the case. The reason:

• The prevailing environment of rising bond yields, in part due to RBI's hawkish policy bias, has hurt the appetite of market participants to take long positions on government bonds.
• In the absence of active demand for government bonds, the relaxed liquidity requirement ends up being held as excess statutory liquidity reserves by banks, and needs to be marked to market. A desire by banks to offload this excess, in the absence of forthcoming demand, simply results in higher yields.
• We estimate total SLR held by banks to equal 29.35% of aggregate deposits as of Aug. 31. Subtracting regulatory demand of 24%, that leaves an excess SLR holding of 5.35% with banks or roughly 6.4 trillion rupees.

Yields to Rise Overtime as Market Prices Regulatory Change

There is a simple solution that can ease the strain in the government bond market and at the same time meet the durable liquidity needs of the economy. The central bank could announce a calendar of open market purchases of government bonds. This would give certainty to market participants on an infusion of durable liquidity going ahead. It would also likely ignite positive sentiment in the bond market as over time, it would ease banks' excess holding of government bonds. But the central bank's refusal to even accept liquidity deficit conditions makes this a tall order.

Abhishek Gupta covers India for Bloomberg Economics in Mumbai. He previously worked as an economist at DSP Merrill Lynch and as a research analyst at the National Institute of Public Finance and Policy, India's premier macro/finance think tank.