The RBI has allowed an additional 2% carve out from SLR for the purpose of liquidity coverage ratio (LCR) maintenance, thereby taking the total carve out available to 15% of net demand and time liabilities (NDTL). Further, the RBI has made a proactive statement listing down steps taken thus far on liquidity (two Open Market Operations (OMO), term repos, LCR dispensation) and has provided further assurance that it “stands ready to meet the durable liquidity requirements of the system through various available instruments depending on its dynamic assessment of the evolving liquidity and market conditions”.
We discuss briefly possible implications of the move:
1. This is consistent with our thought that financial conditions are too tight and the RBI will incrementally be pushing against this tightness in the interest of financial stability (please refer our note “Too Tight? A Market Update”, dated 24thSeptember for details). The premise is that market is currently overpricing incremental tightening in rates and liquidity given that financial conditions have already tightened significantly. The current move is one step further that will sit in dissonance with market thinking, but is consistent with our framework.
2. The headline number on liquidity that gets ‘freed up’ (in excess of INR 2 lakh crores) is probably a gross exaggeration. The move will likely largely be beneficial only to private sector banks that were facing LCR constraints and will ensure that the pressure to raise longer deposits (including CDs) subsides at least for the time being.
3. This move doesn’t create additional permanent liquidity. It is possible that the RBI may not feel pressure now to anticipate future tightness and proactively create permanent liquidity immediately. However, LCR dispensation is no substitute for permanent liquidity creation, and neither are term repos beyond a point. As said here many times before, core liquidity deficit will probably be higher than 2% of NDTL of banks by March if the RBI doesn’t take permanent infusion steps. Thus we still fully expect OMOs to happen, though they may be more spread out now that RBI has contained the immediate stress in money markets.
All told, the move is very important as a signaling tool for continued policy pushback against excessive financial tightening. It will alleviate stress in money market rates and front end bonds immediately (rates are down around 25 bps at time of writing). The continued underlying trade should remain one of fading the excess discounting of incremental tightening. This is best played through sovereign and AAA front end.
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