For the market to derive comfort with this system, it needs to be clarified and demonstrated whether the RBI is managing only liquidity, or also signalling interest rates. If the system is just to manage liquidity, then on any given day, the RBI should accept bids either of repos or reverse repo (and not both).

The RBI has been following this till now. However, on reporting Friday, there was strong evidence of shortage of liquidity: call money rates were in the 11-12 per cent range in morning deals and over Rs 14,000-crore refinance was drawn down. However, all bids for reverse repo were rejected. Being the reporting Friday, borrowing banks had no leeway, and had to borrow at any rate. Lenders had a field day, and call rates shot up to 30 per cent.

That there was a shortage in the system was evident on Saturday too, as call rates opened near 30 per cent and closed near 12 per cent, despite banks needing to cover only 65 per cent of their reserve requirements. Call money is likely to open the week above 10 per cent. A lot depends on whether operational issues of LAF, such as time of announcement of results, can be smoothed out. Also, consistency in providing sufficient liquidity would provide market participants with greater comfort with the system.

Rupee settles down
After the volatile behaviour of the previous week and verbal intervention, currency markets stabilised last week. The rupee traded between 44.68 and 44.75 a dollar, closing near 44.70. Foreign currency reserves have dropped by $214 million in the week ended June 9 (intervention?). At the moment, the rupee appears to have stabilised, and could stay near current levels for some time.

Gilts prices drop further
Sentiment continued to remain bearish, with medium-term securities losing 20 paise over the course of the week, while trading at the long end was practically absent. Since the last auction, yields at the short- and medium-end have risen by 10 to 20 basis points. Liquidity during the coming fortnight is expected to remain tight, as tax outflows to the tune of Rs 4,000-4,500 crore are scheduled, with no sizeable inflows. The liquidity position is unlikely to ease till July, when inflows of coupons and redemptions total about Rs 14,000 crore.

However, these inflows are expected to be negated by issuances of government securities. Till date, only 32 per cent of the budgeted borrowing program has been completed. Considering that historically 75-80 per cent of borrowings are completed before the start of the busy-credit season in November, about 48 per cent of the program, or Rs 56,000 crore of gross borrowings, is likely to be completed in the next four months. Last year, about 12 per cent of the gross borrowing program was executed in July. Considering the size of inflows in July, we expect around 15 per cent of the budgeted gross borrowing programme (about Rs 17,000 crore) to be conducted in July.

Thus, despite good inflows, we are unlikely to witness comfortable liquidity, though there might be pockets of liquidity. Further, as Tier I refinance is currently almost fully utilised, net inflow of at least Rs 10,000 crore would be required to push call rates below the 7 per cent level. Given the likely tight liquidity scenario, we maintain a low duration portfolio.