Cue from Fed: RBI may ease liquidity

After rupee recovery and US Fed's decision, banks hope for some loosening on LAF & in MSF rates, among other things

With the rupee recouping much of its losses since May, banks are looking for a withdrawal of liquidity tightening, at least partially, as the tight money market conditions impact their profitability.

"The US Fed's decision gives more elbow room to RBI and they may roll back partially...however, a cut in key policy rates may not happen due to rupee volatility and inflation risks," said Radhika Rao, economist, DBS Bank.

Since mid-July, the central bank had capped banks' borrowing from its Liquidity Adjustment Facility (LAF) to 0.5 per cent of their net demand and time liabilities (NDTL). This forced banks to go to the Marginal Standing Facility window for daily requirements but RBI also raised the MSF rate by 200 basis points (bps), to 10.25 per cent. These measures ensured short-term rates adjusted to the MSF rate, so that the cost of money became dearer. The liquidity tightening was aimed at curbing speculation in foreign exchange, which was adding to the rupee's weakness.

Now that the falling momentum of the rupee has halted and the US Federal Reserve has decided to continue with the same pace of monthly purchase of bonds, market participants expect the central bank to cut the MSF rate by at least 50 bps.

"We expect RBI to reduce the MSF rate by 50 bps to 9.75 per cent. We believe it will likely phase it out altogether in December, once the foreign exchange raised by the FCNR(B) deposit-cum-swap facility is fully known on November 30," said Indranil Sengupta, India Economist, Bank of America Merrill Lynch.

The market also expects banks to get more space for borrowing under the LAF. As noted earlier, they're presently allowed to borrow only up to 0.5 per cent of their NDTL from here. The expectation is for this to be raised to one per cent. Banks pay 7.25 per cent for funds borrowed from the LAF, as compared to 10.25 per cent under MSF. They've been borrowing around Rs 1 lakh crore daily from the MSF window in recent times. This has raised their cost of funds and put profitability under pressure.

In addition, bond market players expect open market purchases of securities to resume, helping to keep the yields on government paper.