On 8th January 2021, RBI announced restoration of variable rate reverse repo (VRR) operations with announcement of a Rs 2 trillion 14-day VRR for 15 Jan 21. RBI reiterated that it was resumption of its Feb’2020 liquidity framework which was suspended last year in light of allowing market participants more flexibility during Covid disruptions. To recap, the Feb’20 liquidity framework had called for continuity of weighted average call rate to be the operating target using the 14-day variable repo/reverse repo operation coinciding with the CRR maintenance cycle as the main policy tool. While this measure enables banks to bid higher than reverse repo rate, & hence can help moderately nudge up call & tri-party repo (TREPS) levels, from a policy standpoint, it doesn’t mark any new liquidity initiative but is continuation of other recent normalization measures like extension of market timings.
In recent months, as system liquidity (banking system liquidity + govt cash balance) increased to in excess of Rs. 8 trillion due to RBI’s sterilization of FX flows, it led to considerable collapse in overnight rates. Coupled with lower demand for short term credit from prime banks & corporates, this resulted in severe fall in treasury bill (t-bill) rates with the 3-month T-bill cut off printing at the low of 2.92% on 25th Nov, 2020, 43bps below reverse repo rate. Understandably this resulted in concern amongst market participants & economic commentators including MPC members regarding policy efficacy & many market participants expected RBI to act in its December policy to correct this polarity. RBI as stated in its December post policy conference, however, regarded the collapse in overnight rates primarily due to asymmetrical distribution of liquidity which it expected to even out as banks intermediate these flows. We believed it was the sensible decision at the time given the fragile nature of recovery & risk of market participants considering it some sort of reversal of its stance.
We believe introduction of VRR is the most pragmatic & less disruptive amongst the other measures that RBI could have chosen to normalize, like opening up of reverse repo windows to mutual funds/insurance or introduction of Standby Deposit facility (SDF) at higher than reverse repo rates. Opening up of reverse repo to MFs/Insurance or SDF could have led to a sharp escalation in money market rates. While RBI can introduce more term reverse repo operations under the framework, the first announcement pertains only to the introduction of the main policy tool which is the 14-day reverse repo. The amount under consideration is INR 2 lakh crore. To put this in context, core system liquidity surplus currently is around INR 8 lakh crores. Moreover, this measure doesn’t address the distribution of liquidity in the system. Thus, if collateralized overnight rates were lower owing to liquidity distributed with participants that don’t have access to the RBI window, this problem continues to remain. Further, it is a voluntary measure for banks which are any way currently “impounding” their liquidity with RBI on an overnight basis under daily reverse repo.
The channel of transmission to money market rates may instead happen, if at all through 2 ways: a) the potential for some more volatility in overnight rates as available daily system surplus reduces (the effect is expected to be marginal as of now since significant surpluses will still remain in the system). b) market may take this as an initial signal towards more concrete measures ahead and starts bidding up the front end rates to price for this uncertainty (this looks like a more meaningful channel as seems to have been present on day 1 post the announcement where 3 months -5 year assets saw a rise in yields by 15-20bps)
Our view as expressed before remains of a slow restoration of normalization, most likely through measured narrowing of repo / reverse repo corridor starting the second half of the calendar year. As expressed in our year end note (“Where the light is”: https://idfcmf.com/article/3568), the automatic CRR unwind, small MSS issuances, if any, etc are par for the course and don’t disturb this view. We would consider the current initiative as even a milder intervention.
Nevertheless, we would look for where the term reverse repo auctions cut off, and whether RBI follows them with more adhoc such term reverse repos. Investors need to be mindful of the possible volatility in upcoming period & firmly re-align their investment allocations with the product’s time horizons accordingly.
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