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`RBI curtailing liquidity to pull up the Indian Rupee (INR) has caused more pain than gain.The INR gained by one Rupee from levels of Rs 60.20 to the USD to Rs 59.20 while the ten

year benchmark bond, the 7.16% 2023 bond price fell by Rs 3. In fact the bond market pain

is not over yet while the INR is actually starting to fall again. The INR has fallen to levels of

Rs 59.50 after the initial rise to Rs 59.20 post the liquidity tightening measures.

Bond markets are facing the prospect of a prolonged spell of uncertainty. Markets will

worry about rate hikes in the 30th July 2013 policy review. Liquidity conditions will stay

tight as banks hoard liquidity on the back of worries of more liquidity tightening measures

and interest rates are unlikely to come off in the economy.

The first hiccup of the RBI moves was seen in the State Development Loan auction held on

the 16th of July. Ten states participated in the auction and the cut offs for the ten year loanranged from 8.50% (Harayana) to 9.48% (West Bengal). The wide disparity in cut off yields

was due to markets bidding negatively in the auction. Five states did not accept the auctionbids.

The second hiccup was seen in the 91 day and 182 day treasury bill auction held on the 17 th

of July where the RBI rejected all the bids for the Rs 12,000 crores auction, as bids would

have come in way too high from market levels.

RBI had to open a repo window for liquidity requirements of mutual funds as the sharp rise

in yields could lead to large scale redemptions from fixed income funds. The liquidity

tightness would mean that there could be no buyers for the securities mutual funds sell tomeet redemptions.

The sharp rise in government bond yields will make borrowing costlier for the government

as well as corporates. The government cannot afford a rise in interest costs at a time when

the economy is slowing down. The government is fiscally constrained and cannot borrowand spend and whatever spending it has to do should come out of budgeted borrowings.

Credit growth in the economy has fallen to multi year lows of 13.7% and rise in borrowing

costs for corporates will slow down credit growth further.

Investors in bonds and equities will be inclined to pull money out of the markets given the

uncertainty on liquidity, interest rates and the INR. Money going out of markets will furthertake up bond yields and pull down equities leading to fresh worries of FII sales and further

falls in the INR.

The fact that RBI announced its liquidity tightening measures late in the evening on the 15 th

of July suggests the government involvement in the measures. The move came after a

meeting of the PM, FM and the RBI Governor. The government is definitely hurt by the RBI

measures as its borrowing cost are higher and prospects of a falling economic growth loom

ahead.

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The worry now is what if the INR goes back over Rs 60? Will the RBI tighten liquidity

further and raise rates? The damage to market sentiments has been severe and RBI cannotundo the damage quickly as then it would seem as if the central bank acted in haste.

RBI has many more things to worry about now and markets are too nerve stricken to take

any position based on fundamentals.

Regards

Kirang Gandhi