Science Of Auction Repo
A major rail disaster occurred less than ten years ago at Perumon near Quilon when several bogies of Island Express capsized into the backwaters from the bridge. When the forklifts and cranes failed to lift up the bogies from the water, a skilled group called Khalasis from the hamlet of Beypore near Calicut were pressed into service to salvage the capsized bogies. They accomplished the task through the adept use of pulleys and crowbars.
A crowbar pivots around a fixed point called the fulcrum. Stronger the fulcrum, more will be the output. The output is also directly proportional to the force applied on the crowbar. The third determinant of output is the distance between the fulcrum and the point of application of the force. The farther is the point of application of force from the fulcrum, greater is the output.
The level of response to the auction repos gives a reasonable measure of the liquidity in the system for the market players as well as the RBI and government. The repo rate also sprouts a level at the short end of the yield curve.
Drawing an analogy between the crowbar and the auction
repo process, the repo rate acts as the fulcrum. The quantum of
money locked up in the auction repo will lend strength to the fulcrum. The residual surplus in the system made available by the lenders in the inter bank call money market will be the force of the crowbar.
The demand from the borrowers in the call money market will be the output. The strength of the fulcrum and the force acting on the crowbar will be complementary as they add up to the total liquid funds in the system. As the fulcrum gains strength, the force becomes weaker.
The prevailing call money rate will be the barometer for measuring the efficiency of the crowbar. It is in the interest of lenders in the call money market that the instrument attains optimum efficiency. By lending more strength to the fulcrum, the lenders will be reducing the force acting on the crowbar. When the lenders are able to bring down the force ( lendable surplus) to less than the output ( borrowers demand for call money), the call money rate will rise to above the repo rate. By locking up a substantial portion of the lendable surplus in the auction repo, the lenders will be able to push up the realised yield on the aggregate surplus to above the repo rate level.
The abysmally low levels of call money rates and relatively higher levels of the auction repo throws up opportunities for borrowers in call money market also to benefit from the yield differentials. The four hundred basis points differential between call money rate and auction repo rate, prevailing at present, enables the borrowing banks to build up surplus products for CRR and lock one third of the surplus over a three day auction repo and benefit from the arbitrage, without creating an asset liability mismatch. The market players must also realise that the quantum of bids received in the auction repo indicates a bloated measure of liquidity owing to the participation from the arbitrageurs. The downward pull on the repo rate will also be exercised more by such participants.
The seven letter word AUCTION has lent credibility to the four letter word REPO which otherwise would have conjured up unpleasant memories of the scam. It is upto the market players to learn and unlearn from the khalasis and optimise the efficiency of the tool. This will lead to substantiate the science of financial engineering over the art of macroeconomic management.
Ramesh Krishnan is money market dealer at State Bank of Travancore. The views expressed here are his own.