RBI’s Liquidity Measures Drive CP Rate Hardening 2023
In the economic landscape, the behavior of interest rates plays a fundamental role in shaping the direction of financial markets, borrowing costs, and investment decisions.
Among these rates, the Commercial Paper (CP) rate, which reflects the cost of short-term borrowings for businesses, can be particularly sensitive to liquidity conditions.
The Reserve Bank of India (RBI) has tightened the reins on liquidity, which has resulted in a substantial increase in rates for commercial papers (CPs) with short maturities during the previous two months.
Non-banking financial businesses (NBFCs) have been worst hurt by the approximately 40 basis point increase in CP rates with a maturity of two to three months since August.
High CP rates increase the cost of short-term financing for businesses, which is not good news. CP is a type of financial instrument that businesses issue to satisfy their short-term funding needs on the money market.
According to statistics from the National Securities Depository Limited (NSDL), corporations raised $1.21 trillion in September through their CP issuances after raising Rs 91,764 crore through 381 CP issuances in July. This shows a significant supply of these papers.
The rate increase has had the most impact on NBFCs since they now need to raise money at a rate of 7.40–7.55% rather than 7.03–7.15% at the beginning of August.
The RBI’s move to apply the ICRR has been instrumental in sucking up extra liquidity. On August 10, RBI governor Shaktikanta Das said that banks would need to keep an internal capital ratio (ICRR) of 10% on deposits that increased between May 19 and July 28 in order to remove $1 trillion in excess liquidity from the banking system. The RBI has begun holding variable rate reverse repo (VRRR) auctions in addition to enacting the ICRR to remove excess liquidity.
Over recent months, CP rates have been observed to harden, a development largely attributed to the Reserve Bank of India (RBI) taking measures to tighten liquidity. Here, we delve deep into the reasons behind these hardening rates and the implications for the broader economy.
Commercial Paper represents a short-term unsecured promissory note issued by large corporations to raise funds for meeting their immediate financial needs. The maturity period typically ranges from a few days up to a year. The interest rate or yield on a CP, often known as the CP rate, is determined by the creditworthiness of the issuer and prevailing market conditions.
The RBI, India’s central bank, uses various monetary policy tools to manage liquidity conditions in the banking system, which in turn influences interest rates in the economy. One such tool is the repo rate—the rate at which banks borrow money from the RBI. A hike in the repo rate usually results in an increase in borrowing costs across the system, leading to a rise in market interest rates, including CP rates.
The RBI has a mandate to maintain price stability. If inflation expectations are on the rise or actual inflation rates breach the central bank’s tolerance threshold, the RBI may decide to tighten liquidity to curb excessive demand.
Overly abundant liquidity can sometimes lead to asset bubbles and irrational exuberance in financial markets. By tightening liquidity, the RBI aims to ensure that credit growth is aligned with the economy’s productive capacity.
Liquidity conditions can influence capital flows and the foreign exchange rate. In periods where there are concerns about exchange rate volatility, tightening liquidity can be a tool to stabilize the rupee.
As CP rates rise, businesses face higher costs to roll over or issue new commercial papers. This can impact their profit margins and reduce available funds for capital expenditure.
Faced with rising short-term borrowing costs, companies might consider longer-term financing options, such as term loans or bonds, even if they come at a slightly higher absolute cost.
Investors in money market mutual funds, which invest significantly in commercial papers, might see higher yields due to the hardening of CP rates. However, there’s also an associated risk if any issuer faces difficulty in honoring their obligations.
While the RBI’s move to tighten liquidity aims to ensure macroeconomic stability, it’s crucial to strike a balance. Excessive tightening can stifle growth, especially in sectors that rely heavily on short-term borrowings. It will be interesting to observe how the central bank navigates this intricate dynamic in the coming months, especially as it gauges the recovery trajectory of the Indian economy post-pandemic.
The hardening of CP rates in response to RBI’s liquidity tightening measures underscores the interconnectedness of monetary policy actions and broader market dynamics. Businesses, investors, and policymakers alike must remain vigilant and adaptive in this ever-evolving economic environment.
