With Rs 40,000 crore going out of the banking system due to advance tax payments, the cost of funds, in the short-term money market, will operate close to the repo rate (6%) — the rate at which the Reserve Bank of India (RBI) makes available overnight funds to banks. Tax outflows have led to a marked cash crunch in the system. On Friday, banks borrowed Rs 42,290 crore from RBI through its repo window. This borrowing is reflective of the fund shortage in the system.

Most treasury heads expect the repo rate, or the rate at which RBI lends to banks, is likely to be the effective policy rates for the coming weeks. This would mean that money market rates would hover around 6% — the repo rate, following the 25-basis-point hike on Thursday.

But bond yields continue to remain steady, as dealers expect that prospects of future rate hikes has eased. “We think that the yield on the benchmark 10-year bond will remain protected at 8%,” said Anoop Verma, DCB. But at the shorter end, rates are expected to rise, following the increase in the repo rate. On Friday, the 7.80% 2020 bond closed at 7.98%, up from Thursday’s close of 7.96%. The immediate impact of the liquidity crunch is an upward spike in short-term rates. “Tax outflows will ensure that liquidity remains tight until they are ploughed back into the system which can happen by the end of the month,” said Roy Paul, DGM, Federal Bank.

The repo rate has been revised to 6% from 5.75% by RBI in its mid-policy review released on Thursday. RBI has narrowed the LAF or the repo-reverse repo corridor by 50 basis points by increasing the repo rate by 25 bps and the reverse repo rate by 50 bps to 5%. “The policy was markedly hawkish than most market participants expected. The rate action and the narrowing of the corridor clearly signals RBI’s emphasis on inflation management and comfort with growth per say,” said Hemant Mishr, MD and head of global markets, Standard Chartered Bank.

However, the measure will reduce volatility of short-term rates, thereby ensuring more efficient transmission of monetary policy, he said. Stability of short-term rates also help banks price their deposits and loans better. RBI, in its mid-policy review statement, said, “The lead-up to the July policy review saw the liquidity situation transit from a large surplus to a mainly deficit one, making the repo rate the operative policy rate. Consequent on this transition, the transmission from policy rates to market rates has strengthened, with 40 banks raising their deposit rates and 26 raising their lending rates. These circumstances are expected to prevail, maintaining the repo rate as the effective policy rate and sustaining the strength of the transmission mechanism.”

Bankers also feel that they have surplus SLR securities which would allow them to borrow from RBI through the repo window. The basic difference between borrowing from RBI and borrowing through the inter-bank route is that banks can borrow from RBI only against securities, but they don’t need securities backing collateral, when borrowing from each other.

Harihar Krishnamurthy, treasury head, First Rand Bank, says, “With the advance tax payment having exited the system, there is a temporary shortage of liquidity in the market, though system has enough surplus SLR, which can be used to obtain funds from RBI’s repo window.” He added that the tightness would come off as soon as government spending resumes.

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