With the liquidity overhang returning to haunt the markets, bankers are preparing for a wider repurchase and reverse repurchase band.

At Fridays weekend Liquidity Adjustment Facility (LAF) auction, the Reserve Bank of India mopped up Rs 37,950 crore through the reverse repurchase window from 34 bidders that included banks and primary dealers. The mop-up was a complete reversal from the last few weeks, when the recourse was mostly to the repurchase window at the LAF auctions.

Bankers said that among the key factors that contributed to the large mop-up were the low credit off-take and liquidity from advance tax collections. The Syndicate Banks General Manager (Treasury and Investments), Mr Vinay Ranjan Rao, said: There were some large inflows into the banking system due to advance tax collections.

However, bankers also said that some liquidity was from foreign banks resorting to arbitrage between the low dollar interest rates and the high rupee rates. Besides, some of the foreign banks have also pitched for the 91- day Treasury bill driving down the cut-off yields by 30 basis points on a week-on-week basis to 6.94 per cent at Wednesdays T-bill auctions. The US Federal Reserve Boards drop in the key Fed Funds rate two weeks ago resulted in creating the arbitrage opportunity. The effective mechanism was to borrow dollar overnight and sell the same against rupees in the domestic market. The rupee funds generated were parked in reverse repo window of the RBI at 6 per cent. This window currently offers spreads of about 2 per cent even after factoring the forward cover. Bankers said that arbitrage flow was one major factor that contributed to the reversal in the rupees retreat against the US dollar and also a simultaneous hardening of short term forward premia.

One month forward premium rose to 2.10 per cent on Friday, up from the mid-March level of 1.8 per cent. The arbitrage-driven inflows buoyed the rupee to 39.95 from a low of 40.77 against the dollar from the middle of last month. The ascent of the rupee was despite the FII-led outflows continuing unabated. Since the beginning of this month, the net FII-led outflows were $297 million according to data from the Securities Exchange Board of India.

Consequently, bankers said that the RBI was expected to step in to plug this arbitrage window, through a reduction in the reverse repurchase rates from the current levels. Besides, the continuing inflation spikes are also causing concern. Inflation as measured by the wholesale price index was 7 per cent, the highest since 2004-end. HDFC Banks Chief Economist, Dr Abheek Barua, said: A hike in the repo rate or a hike in the CRR hike is likely to contain the inflation advance. However, he added, the hike in the monetary policy rates was unlikely to spark any lending rate hikes since credit off-take was still low.

C. Shivkumar