RBI squeezes liquidity

LAF capped at Rs 75,000 cr, marginal standing facility rate increased 200 bps to rein in rupee

In a move to check the currency's volatility, the Reserve Bank of India has decided to lower rupee liquidity in the system by capping the liquidity adjustment facility at (LAF) Rs 75,000 crore from Wednesday.

As a result, the marginal standing facility (MSF) rate has been raised 200 bps to 10.25 bps. The MSF rate is considered a penal rate and banks avail of this as a last resort. Accordingly, the bank rate also stands adjusted at 10.25 per cent.

RBI has also decided to conduct open-market sales of government securities worth Rs 12,000 crore on July 18 which will further suck rupee liquidity out of the system.

The move also raises concerns over the continuation of the policy-easing path that had been adopted by the central bank, as it has now decided to cut the comfortable liquidity the market had been enjoying.

As an immediate impact, overnight rates, hovering around seven per cent, will shoot up. Also, yields on bonds across maturities will harden.

"The market perception of a likely tapering of the US' quantitative easing has triggered outflows of portfolio investment, particularly from the debt segment," RBI said in a late-evening press statement. Foreign investors pulled out nearly Rs 8,500 crore from the debt market in the past fortnight amid concerns over a falling rupee.

Noting that the rupee had depreciated (six per cent) against the dollar over the past six weeks, RBI said: "Countries with large current account deficits, such as India, have been particularly affected, despite their relatively promising economic fundamentals.

The exchange rate pressure also evidences that the demand for foreign currency has increased vis-a-vis that of the rupee in part because of the improving domestic liquidity situation."

Banks' borrowing via RBI's LAF facility has come down sharply in the past few months from more than Rs 1 lakh crore. Today, however, banks borrowed over Rs 90,000 crore from RBI.

Experts said if liquidity was choked, it would impact cost of borrowing for companies.

"These steps will take out some liquidity, making rupee borrowings costlier. The market players will stay in rupee and go short on dollars. The money market is closely inter-linked with the foreign exchange market. So, the steps to curb liquidity in the money market may show effect in the currency market," said Moses Harding, former treasury head of IndusInd Bank.

The RBI announcements followed an emergency meeting between Finance Minister P Chidambaram and RBI Governor D Subbarao in New Delhi earlier in the day. While no one was willing to comment on the deliberations, the issue of sovereign bonds was reported to have come up.

RBI and the Securities and Exchange Board of India had moved against currency speculators last week, without much effect. While the central bank told commercial banks they couldn't trade on their own account in the exchange-traded currency derivatives market, Sebi cut position limits drastically and doubled the upfront margin requirements.