RBI Comes to Fund's Rescue | Value Research The increasingly severe liquidity crisis has started hitting cash funds--and the RBI has stepped in to solve the problem

RBI Comes to Fund's Rescue

The increasingly severe liquidity crisis has started hitting cash funds--and the RBI has stepped in to solve the problem

Over the last few days, the side-effects of the global financial crisis have reached some of the funds run by the Indian mutual fund industry. Now, RBI has decided to provide a temporary credit line to funds to enable them to bridge the gap between redemption requests and the sale of underlying securities.

The move comes in the shape of a special Rs 20,000 crore credit line to banks which is to be used to provide 14-day credit to funds. The central bank will conduct a special 14 day repo at 9 per cent per annum for the notified amount of Rs.20,000 crore.

Here's a detailed backgrounder on the problem. Last Friday, something unprecedented happened-some mutual funds of the 'Liquid Plus' type made a loss over the previous day, i.e., their NAVs for Friday were actually lower than their NAVs for the Wednesday, the previous day when the markets were open. The number of funds affected were not large-in all about five funds out of 36 showed a loss.

These losses are important for two reasons. One, this type of funds is supposed to be an ultra-safe one that shouldn't have any losses ever. And two, this could well be the harbinger of a deeper problem that could become serious over the next few days. In the coming days, perhaps as early as Monday, the same problems could hit cash funds and perhaps some other debt categories also.

Let's take a look at what these funds are and why these losses are significant. Liquid Plus funds are a variation on liquid funds, which are also called cash funds or ultra-short term funds. These funds are typically used by companies as a substitute for bank deposits. Typically, they earn a little more than bank deposits and are more tax-efficient. The underlying investments that these funds make are chosen for safety and, obviously, liquidity. Liquid funds invest in debt instruments that a very short maturity. The ultra-short term means that these instruments have very low risk.

Liquid plus funds are a variation on the liquid fund theme. Liquid plus funds are somewhat riskier, but at the same time they offer slightly higher returns and are subject to lower taxation. Dividend distributed by liquid plus funds is subject to an effective tax rate of 22.7 per cent while plain liquid funds' dividends are taxed at 28.3 per cent. Coupled with the slightly higher returns, this makes a big difference to companies who are parking huge amounts for short periods of time.

Unfortunately, the higher returns come at the price of higher risk. Liquid plus funds invest in instruments that have a longer tenure and are therefore subject to more risk. For a long time, this risk appeared to be merely theoretical. However, in these times of global risk-aversion, this risk has become real.

Since these are open-end funds, fund companies have to honour any redemption requests within one day. Redemption requests have to be honoured by selling the underlying instruments. Over the last few days, it appears that fund companies have had trouble making redemptions because the underlying instruments are becoming difficult to sell. The deep risk aversion and credit worries that have gripped financial markets have meant that debt assets that should have been easy to sell have proven near impossible to sell.

On Friday, a few fund companies seem to have honoured redemptions by selling some investments at whatever price they could get. This price was obviously lower than what the instruments were valued at. As a result, NAV has dropped and the funds' investors have borne losses. The losses may look tiny to equity investors but they are a big deal for liquid funds. The root cause is that liquid funds were being bought under the assumption that their risks were negligible. However, negligible does not mean zero.

The conventional framework for estimating risk in these funds has always assumed that each investment was a separate, unrelated risk. However, the way things are turning out, large swathes of the world's financial system have suddenly turned risky.

Now, it appears that the RBI's quick action will prevent a dislocation of the credit market supported by cash and liquid plus funds.

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