The combination of the current liquidity deficit and the RBI’s response of open market operations will benefit swap flatteners and bullish bond view, according to Nomura
Global brokerage firm Nomura believes that India’s total system liquidity is declining again, in line with its expectations. The brokerage has put out a brief update on current liquidity conditions and notes reasons for the deficit. The Reserve Bank of India (RBI) can respond with open market operations (bond buybacks) as soon as May. The combination of the current liquidity deficit and the RBI’s response of open market operations will benefit swap flatteners and bullish bond view, according to Nomura.
Entering April, one of the key discussions among the rates market participants was the expected improvement in liquidity conditions from government spending. At that time, Nomura noted that banking system liquidity should improve in April. However, it believed it would remain in deficit mode. The brokerage also mentioned that the total system liquidity should worsen, as currency with the public leakage will remove significant liquidity from the banking system.
Liquidity conditions are developing in line with Nomura’s expectations. Banking system liquidity improved as the government spent a significant amount in April; its surplus fell from an estimated Rs1.2 trillion on 29 March to nearly Rs350 billion on 19 April. This led to a reduction in daily LAF (Liquidity Adjustment Facility) borrowings, from an average of Rs1.5 trillion in the second half of March to an average of Rs800 billion in April. However, the total system liquidity deficit (banking system liquidity deficit + government cash surplus) has worsened over this period. Nomura estimates the total system liquidity deficit was approximately Rs650 billion as of 19 April, which is significantly higher than the total system liquidity deficit as of 29 March, estimated at Rs300 billion. It notes that most of this increase can be attributed to currency with the public leakage.
As the country enters a new fiscal year, two drivers of liquidity are having nearly opposite effects. Government spending is improving liquidity conditions in the banking system, while currency with the public leakage is withdrawing significant liquidity. Nomura also noted earlier that, since the global financial crisis, currency with the public leakage during April has averaged almost 25% of the total leakage for that fiscal year.
Nomura’s theory to explain this seasonality is that, as the fiscal year-end approaches, commercial banks attempt to enhance deposits to meet their fiscal year-end deposit targets. However, a portion of these deposits reverse in the month of April, which is reflected as currency with the public leakage (there are also likely other reasons associated with the increased transactional use of currency, which reflects increased business activity at the beginning of the fiscal year). All in all, currency with the public leakage, which has been the largest driver of the liquidity deficit in the post-crisis era, is normally a significant drag on liquidity during the month of April. This trend has continued, as currency with the public leakage has resulted in the total system liquidity deficit increasing (banking system liquidity + government balances) this April as well.
Considering these liquidity conditions, Nomura believes the RBI is likely to start conducting open market operations again as soon as May, which should further support sovereign bonds. It estimates the RBI will conduct Rs1.2-1.4 trillion of open market operations in FY14, with approximately Rs400 billion of purchases made during first half of fiscal year. With no supply in the three year-five year part of the yield curve, the brokerage believes this part of the curve is the best way to express its bullish bond view.
Nomura targets 7.17% on the five-year bond. These current liquidity deficit conditions in conjunction with the expectation of bond buybacks also support the brokerage’s swap flattener view, which it is expressing through 1s3s swap flattener (Current -29bp, Target another 15bp profit inclusive of carry and roll).
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