The Reserve Bank of India came out with a slew of measures on Monday to curb rupee volatility. The intent was clear – to mop up excess liquidity used by banks to take a speculative position in the forward exchange markets. However, the measures seen as a trigger to hike short-term interest rates resulted in one of the highest single-day outflows on Tuesday since October 2008, from various fixed income mutual funds.

In its first measure, the central bank capped the amount that banks can borrow from overnight markets to Rs 75,000 crore. This is essentially the borrowings banks make through the liquidity adjustment facility (LAF). Second, the RBI increased banks’ cost of borrowing short-term money through the marginal standing facility (MSF) by 200 basis points to 10.25 per cent. Currently, banks can borrow funds overnight through the MSF at 8.25 per cent.

Liquidity crunch

This sets the stage for a rise in short-term borrowing rates which will impact the cost of funds for banks. But will banks really need to borrow at the higher rate of 10.25 per cent? As long as banks borrow large amounts of money under the LAF window, they will not be able to lower deposit rates and hence lending rates. Even as the amount borrowed under LAF moderated in June and July, RBI’s third measure to suck out liquidity by selling government securities may create a liquidity deficit once again.

The RBI announced the sale of government securities to the tune of Rs 12,000 crore on July 18 on top of the Rs 15,000-crore sale already announced. Thus, to maintain their margins, banks may end up raising their base rates, to which all lending rates are benchmarked.

Why the reaction

Bond prices have an inverse relationship with interest rates. As interest rates go up, existing bonds become less attractive and hence investors are willing to pay less for them. With expectations of interest rates going up in the short term, the yields (ratio of interest to price of bonds) shot up by 50 basis points in a single day.

This triggered panic in the debt market. Investors, mostly banks and companies, pulled money out of liquid schemes, in which they park idle funds. Liquid schemes invest in money market instruments, short-term corporate deposits and bonds with maturity of three to six months. RBI created a temporary liquidity window to allow banks to borrow Rs 25,000 crore at 10.25 per cent. This was to enable banks to meet the liquidity requirement of mutual funds, which faced huge redemption pressure.

Yields on the 10-year gilts which had plunged sharply to 7.1 per cent in May on expectations of rate cut reversed course significantly last week and now hover around 8 per cent.

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