Earlier this month, the Secured Overnight Financing Rate (SOFR), a global benchmark used to determine the price of US dollar-denominated loans and derivatives, jumped to an all-time high of 5.39%, Bloomberg reported. The development occurred due to turbulence in US funding markets and overnight repo transactions amid quantitative tightening by the Federal Reserve.
Meanwhile, ET reported on Wednesday that Indian companies are showing strong appetite for dollar loans, with firms set to borrow more than $25 billion abroad this year. What is the link between the SOFR and Indian corporate fundraising plans? What does the volatility in US funding markets mean for the American banking sector, which suffered a crisis in March 2023? How does the elevated cost of funds in the US percolate thousands of miles away to Indian corporates?
What is the repo market?
A repo, which stands for a repurchase agreement, is in many ways the fundamental building block of money markets the world around. Essentially, the transaction involves financial market players like banks borrowing and lending money overnight using government securities as collateral. Banks typically need funds for a host of reasons, including mandatory reserve requirements. Usually, the interest rate for overnight repos is closely linked with the central bank’s policy rate – for example the Reserve Bank’s repo rate in India.
What is derived from the repo market?
Benchmarks that are used to decide the pricing of a variety of credit products such as loans are derived from instruments belonging to the money markets. In the US, the SOFR is decided based on the prevailing rates in the repo market. Subsequently, the SOFR is used to decide the pricing of loans the world over that are denominated in US dollars. In India, the Mumbai Interbank Outright Rate (MIBOR) is derived from the weighted average rate in the call money market. The MIBOR is used for pricing a host of crucial products used by banks and corporates for financing needs such as interest rate swaps.
Is a crisis brewing?
Citing US market analysts, Bloomberg’s report said the stress in the repo market was reminiscent of a funding crisis in 2019 which was also characterised by high rates and scant liquidity. A sudden surge in overnight cost of funds could exacerbate stress for banks in need of money, especially at a time when the US government is draining a lot of liquidity from the country’s banking system through its huge issuances of bonds. Barely nine months ago, three US banks collapsed, with losses on government security portfolios playing a major role amid sharply higher interest rates.What are the implications for India?
Amid expectations of the US Federal Reserve having reached the end of its rate hike cycle, Indian corporates are looking to tap the dollar route and raise funds overseas. Some foreign bankers estimate more than $25 billion of dollar loans to be raised this year by domestic firms. These loans are priced at a spread over the SOFR, as are the interest rates on dollar bonds issued overseas. A fresh rise in the SOFR, notwithstanding whether the Fed hikes rates or pauses, would make it that much more expensive for Indian players to access the overseas loan markets.
