RBI's liquidity ops for banks a temporary fix; cash still in short supply

The banking sector liquidity continues to remain in deficit despite the various modes of liquidity operations by the Reserve Bank of India (RBI) in the past financial year.

The central bank bought about Rs 3 trillion, or an equivalent of 71 per cent of fresh bonds issuance last year from the market, as well as swapped $5 billion for rupee with banks, injecting another Rs 35,000 crore of rupee liquidity into the market. Another $5 billion swap for three-year period is due on April 23.

The open market operations (OMOs), through which the central bank bought bonds, and the dollar swaps, both affected the bond and currency markets. Contrary to what the central bank’s stance could be on markets, the measures did distort the bond and currency markets. 

By buying such huge bonds from the market, the bond yields came down. This runs counter to the recommendations of one of the central bank’s committees. The Urjit Patel committee on monetary policy framework advocated reduction of banks’ statutory liquidity ratio (SLR) so that the yields reflect market reality, and not any administered mandate. A massive OMO suppressed bond yields. 

In currency market, forward rates crashed, which is subsiding importers to hedge against their long-term foreign currency loans. 

Distortion, though, is not necessarily a bad thing. But specifically, using a three-year tool in a dynamic world could have its own ramifications going forward even as they are not known yet, according to Ananth Narayan, associate professor, SP Jain Institute of Management and Research.

The idea of the swaps, though, is not new and is practiced regularly by other central banks. 

“If you look at the central banks around the world they do use foreign exchange swap facilities. Singapore’s monetary policy is linked to the exchange rate. It is actively, heavily using foreign exchange swaps for liquidity management. That’s why the swaps are there,” said Ranil Salgardo, mission chief for India at the International Monetary Fund. 

Currency dealers say the central bank has the scope to do another $5 billion swap, considering that banks have extra dollar holding. This became apparent on the last trading day of fiscal year 2018-19 (FY19) when the cash-spot spread spiked to a record high. Extra dollar brought by the banks to take part in swaps auction led to a problem of plenty as rupee liquidity ahead of the closure of accounts became scarce. 

This also points to a lacuna in the central bank’s policy on liquidity. 

“The RBI needs a comprehensive liquidity framework to accompany the monetary policy. To start with, the liquidity framework must set a daily banking liquidity objective of surplus, neutral or deficit, in line with the monetary policy stance. Second, liquidity operations must have the appropriate timeframe — for instance, withdrawing durable liquidity in the wake of temporary surpluses may not be the right approach. Lastly, the tools for liquidity management must be chosen with careful regard for their inevitable side-effects,” said Narayan.

“Too much of bond open market operation distorts the bond curve. Too much of intervention in FX swaps can distort the FX market. There has to be a careful choice of the right tools to manage liquidity, and the side effects have to be anticipated and acceptable. For the time being though, the swaps and the OMOs have been useful in infusing liquidity,” Narayan said. 

The dollar swaps and bond buyback indicate to an expansionary monetary policy environment, according to brokerage house Edelweiss. It said interest rates can go down by another 50 basis points in FY20, after coming down by 50 basis points since February. 

“In the absence of liquidity deficit and crowding out of borrowings by government going further, this should transmit into at least 100 bps cut in bond yields and open the window for easy low cost of credit,” Edelweiss said.

But the RBI’s balance sheet expansion can be inflationary, warn experts. It has happened in the past. 

Between April and September 2009, the RBI purchased Rs 80,000 crore through OMOs and a further unwinding of special bonds worth Rs 42,000 crore under the market stabilisation scheme. This was done in conjunction with massive stimulus packages by the government, and a handsome spike in income to government employees because of the Sixth Pay Commission recommendations.

The wholesale price index-based inflation (the key gauge of price rise then) rate was in negative territory in June 2009. It shot up quickly to nearly 11 per cent in April 2010 and remained high for three years, partly because of oil prices and also because of excess liquidity in the system.

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