The latest Reserve Bank of India (RBI) circular will allow banks to access an additional Rs 2.5 lakh crore by pledging two per cent extra government paper signalling an easing of the liquidity stress. Banks can now dip into government bonds under the mandated Statutory Liquidity Ratio (SLR) up to 15 per cent of Net Demand To Liquidity (NDTL) for meeting liquidity requirements. Hitherto, this cap was set at 13 per cent of government bonds in their kitty. RBI’s latest decision will allow banks to resume onward lending especially in the prevailing highly stressed liquidity conditions following the Infrastructure Leasing and Financial Services (IL&FS) mess that has roiled the non-banking financial companies (NBFCs).

Resumption of lending to NBFCs will ultimately depend on banks’ liquidity position that varies from case to case. The cost of funds would definitely be an issue, as banks themselves cannot access excess liquid funds from RBI at the prevailing repo rate of 6.5 per cent. Till September 26, banks have already utilised their quota of Rs 1.88 lakh crore at repo rate. Even if these funds were released into the system, NBFCs will have to fork out through the nose and in turn pass on additional costs to retail and corporate clients. Efficacy of banks and NBFCs will also determine actual deployment of these extra liquid funds to end consumers.

In the given situation, banks are not overtly enthused to do fresh lending to NBFCs. Instead, they may be inclined to park their funds with healthy corporate clients, individual homebuyers or retail borrowers. Given the banks’ hesitation and cost factors, RBI cannot withdraw from open market operations in the immediate future if it were to ensure adequate liquidity in the system. But, one positive fallout from RBI’s Thursday decision would be a fall in short-term rates allowing companies to meet their working capital requirements or take recourse to short-term borrowings at cost effective rates. More than the IL&FS saga, it’s the tightened liquidity that spooked both equity and domestic markets last two weeks. If not anything, RBI’s decision will improve market sentiment.

However, tight liquidity conditions may not improve unless US Federal Reserve adopts a dovish policy and crude oil prices begin to slide. This at best could be a distant dream. The government may have to step in to improve market sentiment with its own set of measures. While it has fewer options, finance minister Arun Jaitley may have to periodically meet up with market participants to deliver a pep talk. Most of his predecessors did this backroom management and perked up the investment sentiment not only in the market but outside. Secondly, measures like restrictions on imports may not particularly improve the sentiment. Thirdly, reassurance from the highest levels about economic fundamentals being robust could help. Fourthly, since the budget exercise was to begin shortly, finance minister may have to seek market specific inputs that could keep the sentiment positive till the next elections.