The Liquidity Conundrum

How much liquidity do we need: Appropriate, adequate, abundant? To inject growth instinct, adequate liquidity needs to complement rate cut

- TAMAL BANDYOPADHYAY

Last Friday, the yield on the 10-year bond dropped to its lowest level in three years. However, corporate bond yields and certificate of deposit rates have been rising. The spread, or interest rate differential between the repo rate and corporate bond yields, has recently widened to 125 basis points (bps), while the spread between central government securities and corporate/state government bonds has increased from 30-35 bps to 45-55 bps. (One basis point is a hundredth of a percentage point.) Bond prices and yields move in opposite directions.

Why is this happening despite a 25 bps rate cut by the Reserve Bank of India (RBI)? The answer is simple: A liquidity shortage in the Indian financial system.

The RBI has been doing everything a regulator can to manage liquidity.

Today, on March 24, it will conduct a three-year, $10 billion dollar-rupee buy-sell swap auction. In such a swap, the RBI buys dollars from banks in exchange for rupees, with a commitment to sell the dollars back after three years. At the prevailing exchange rate, this will inject around ₹86,000 crore into the system.

This follows a similar swap on February 28 and a six-month, $5 billion dollar-rupee buy-sell swap on January 19.

This is not the only instrument in the RBI's toolkit to infuse liquidity. It has been conducting daily variable rate repo (VRR) auctions of different tenures. In such auctions, the RBI supplies money to banks at a market-determined rate.

Besides this, it has also been conducting OMOs, or open market operations, buying government bonds from banks and providing them with liquidity. In March, we saw Rs 1 trillion worth of OMOs in two equal tranches on the 12th and 18th.