RBI extends ad-hoc liquidity-easing measures as crunch persists: Kotak Sec

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Economy
RBI extends ad-hoc liquidity-easing measures as crunch persists. RBI announced an
extension of its ongoing liquidity support measures post market hours yesterday as
liquidity stays tighter than RBI’s comfort zone. The special second LAF window that was
to end on December 16, 2010 is now extended till January 28, 2011. Further,
commercial banks were hitherto allowed an additional liquidity support under the LAF
up to 1% of NDTL till December 16. This facility stands enhanced to 2% of NDTL and
the end date is now January 28, 2011 and will allow banks to borrow an additional
Rs520-Rs530 bn from RBI. Calculations point to liquidity staying in significant negative
territory in the coming months, ensuring that the repo rate remains the operative rate.




Liquidity deficit remains beyond RBI’s comfort zone
The liquidity tightness became evident with the outflows under the 3G auctions by end-May. From
a Monetary Policy angle, RBI shifted its stance to keep liquidity tight from July 2 to ensure effective
monetary policy transmission. RBI had recently indicated that it is comfortable to see the daily LAF
balances as (+/-) 1% of NDTL range (equivalent to (+/-) Rs500 bn) to avoid any disruptions to
financial markets and the broader economy. This was highlighted in the November policy
statement as well. The liquidity crunch has become much more severe in recent times, with daily
LAF balances averaging (-) Rs1,028.3 bn since the beginning of November from (-) Rs580.1 bn in
October and (-) Rs250.78 bn in September, necessitating an RBI action. Further, the move may also
be driven by the fact that additional pressure on liquidity could emerge at the time of the third
installment of advance tax payments in mid-December.

Acute liquidity shortage a result of several factors
The continued pressure on domestic liquidity is a result of several factors at play. (1) Government
spending has been lagging, evident from the high surpluses being maintained by the government
with the RBI. Central Government surplus with the RBI increased from Rs744 bn as of October 15
to Rs865 bn as of November 19. (2) Currency in circulation has also been very strong due to the
festive season demand for cash, recent State elections and also the higher food prices in general.
In the first three weeks of November, the leakage from the banking system on account of currency
in circulation is close to Rs350.8 bn. To set this in perspective, the leakage under this head in a
similar period in the previous financial year was in the order of Rs146.4 bn. (3) Recent IPO related
refunds are likely to have added another dimension to the liquidity pressure. (4) RBI’s hands-off
approach in the domestic currency markets as Current Account Gap has widened significantly.

RBI has adopted a piecemeal approach to address liquidity constraints
So far, RBI has adopted a piecemeal approach to address the liquidity crunch by introducing
temporary measures. On October 29, RBI introduced a second LAF facility and allowed banks to
borrow additionally up to 1% of their NDTL. This facility was put in place till November 1, but RBI
later extended these measures till November 4. RBI reintroduced these measures on November 9,
to be in place till December 16. And this has now been extended till January 28, 2011. In our
opinion, RBI is unlikely to adopt any permanent liquidity injection measures such as a CRR cut in
the immediate future. RBI still has inflation on its radar and with growth appearing firmly in place
(1HFY11 GDP growth at 8.9%), RBI would be watchful of demand-side inflationary pressures
picking up. While headline WPI has been moderating, there are still some upside risks. We expect
WPI inflation to end the fiscal at 6.0-6.5%, higher than RBI’s target of 5.5%. Unless inflation
comes within RBIs comfort zone of 4.0-5.0%, we think that the central bank would continue with
the current adopted strategy of ad-hoc liquidity-enhancing measures and not opt for a CRR cut.
This could also be supplemented at times with OMOs/buybacks.


Liquidity conditions unlikely to improve in the remainder of the financial year
As per our calculations on liquidity for the remainder of the financial year, liquidity
conditions are expected to remain tight. December would see the most pressure on
domestic liquidity as we estimate that close to Rs550 bn to Rs600 bn would go out of the
system on account of the advance tax payments. The total outflow on account of taxes is
thus pegged at Rs1,100 bn, in line with the September numbers. Our end-December
estimate for LAF is around (-) Rs1,168 bn but we keep the possibility of LAF balances
deteriorating to around (-) Rs1,500 to (-) Rs1,600 bn with the advance tax outflows. Our
estimate indicates that only in March, as the government rushes to complete its spending
plans (as is evident in most of the previous years), could there be some comfort on liquidity.
We have modeled government expenditures and currency in circulation for the next few
months in line with the historical trends that have been evident for these months in earlier
years.