Why India's surprising liquidity tightening move may be a huge risk

It's a classic EM response.

According to Deutsche Bank, the surprising liquidity tightening move from (Reserve Bank of India) RBI this week was a classic EM response to currency weakness.  

Deutsche Bank noted that it is risky in that it pits the benefits from short circuiting the currency weakness feedback loop, against the possible cost to growth from higher cost of liquidity getting transmitted through to the real economy.

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And the latter is not trivial, given that the structural liquidity deficit in the banking system is already close to the new restricted limit of repo borrowings, and any further currency intervention would force the marginal cost of INR liquidity to spike.

Again, even from a currency perspective, the move carries the risk of forcing further liquidation of offshore money invested in both debt and equity markets, and widening the current account financing gap.

We are not as convinced as probably the central bank that speculation has had quite as much to do with currency weakness. And to the extent the measures were aimed at narrowing the current account gap, a monetary move looks too heavy handed to deal with the same.

That said, and along with other obvious signs of growing official intent (in the form of intervention, regulatory action, and moves to rebalance dollar net demand in the markets), we think INR vol will in general get pushed lower.

We see selling 1M vol and buying 3M vol on USD/INR via calendar spreads as an attractive way to position for this backdrop of growing official engagement.

The spike in cash bond yields has obviously been fairly punitive as well, given that RBI is using OMO sales as part of its tool kit to tighten liquidity. We move to benchmark on our duration exposure, and will wait for the dust to settle down.

The real test for short term liquidity will likely come in the next bank reporting fortnight.

While short end OIS looks attractive to receive after the recent moves, particularly as we see this RBI move as being temporary; we are reluctant to dive in before we see signs of further cleansing of positioning, and the real impact on bank term structure of rates as a result of this RBI move.