The outlook for liquidity is turning positive and this bodes well for interest rates at the short end of the yield curve. Liquidity conditions are improving on the back of factors such as strong growth in bank deposits and falling trade deficit. The fact that liquidity outlook is improving rules out a CRR (Cash Reserve Ratio) cut by the RBI in its annual policy scheduled for the 3rd of May 2013.
Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI eased by Rs 23,000 crores week on week with bids for repo averaging Rs 74,000 crores on a daily basis last week against an average of Rs 97,300 crores seen in the week previous to last. Liquidity eased as banks demand for funds came off in the second week of the reporting fortnight.
Banks had raised Rs 3.74 lakh crores in the month of March 2013 to shore up their balance sheets for the fiscal year end. The fiscal year end liquidity surge will see deposit outflow from banks in the beginning of the new fiscal year but given that bank deposit growth has surged by 5.7% month on month in March 2013, liquidity will stay comfortable even if banks see deposit outflows in April.
Trade numbers for March 2013 showed trade deficit for the month coming in at USD 10.3 billion against a deficit of USD 14.8 billion seen in February 2013. Trade deficit has almost halved from levels of USD 19 billion seen in November 2012. Trade deficit is likely to be contained in the coming months on the back of lower oil prices that have fallen by over 8% over the last one month. Lower trade deficit is positive for liquidity as foreign exchange outflows reduce.
The government is running a cash surplus estimated at around Rs 80,000 crores and this surplus is parked with the RBI. Government cash surplus impacts system liquidity as the money is taken out of the banking system. Liquidity comes back into the system on government spending. Hence the reason banks are continuing to borrow from the RBI on a daily basis to meet their fund requirements is due to the surplus government cash position. Once the government starts to spend money, system liquidity is likely to turn into surplus from deficit.
The short end of the yield curve will benefit from easing liquidity conditions. Yields on Treasury Bills (T-bills), Certificate of Deposits (CDs) and short maturity corporate bonds are likely to fall as liquidity outlook improves. One year T-bills and CDs are trading at levels of 7.71% and 8.45% respectively while two and three year benchmark AAA corporate bonds are trading at levels of 8.60% to 8.65%. Yields are likely to fall by 50bps at the short end of the curve post RBI 3rd May policy statement where the central bank is likely to cut the repo rate by a minimum of 25bps.
A 25bps repo rate cut will take the repo rate to 7.25% from 7.5% and if the RBI cuts rates by 50bps, a good possibility as per our analysis, the repo rate will stand at 7%. Easing liquidity conditions coupled with lower repo rates will push down yields at the short end of the yield curve.