Liquidity glut, ultra low rates may prompt RBI to change course soon

The central bank is unlikely to change its policy stance from accommodative to neutral, any rate hike to control inflation is also out of the question for now
The foreign exchange intervention and plethora of liquidity measures undertaken by the Reserve Bank of India (RBI) staved off a crisis in the banking system, and helped the government borrow a record amount via bonds at more=than-a-decade-low rates, but could it be time now to withdraw some of the accommodation? Experts say yes. 

The bond market has been taking it easy for quite some time now. Despite Rs 12 trillion borrowing programme, top corporates were able to borrow short-term money at below the repo rate. State Bank of India (SBI) group chief economic advisor Soumya Kanti Ghosh also wrote in his report on Wednesday how some banks are even giving 10-15-year term loans at below the bond market rates. There is no avenue to deploy the excess liquidity otherwise. 

On the same day, an auction of treasury bills were done at record low yields. The 91-day treasury bills were sold at just 2.92 per cent interest, 182 days at 3.26 per cent and the 364 days bills were sold at 3.39 per cent. The weighted average overnight call rate is now at 3.34 per cent, dropping to as low as 2 per cent in the intraday on Thursday. The central bank’s objective is to keep the call rates anchored at around the repo rate of 4 per cent.  

Part of the reason why the rates are so low now is because the mutual funds are investing their extra liquidity in short-term instruments, driving short-term rates lower than even the lower bound of RBI’s policy corridor.  

“Money markets work best when market rates remain anchored to the extant and expected evolution of policy rates set by the central bank. Once money market rates start settling either significantly below or above the policy rate corridor then technically the policy rate corridor starts losing its relevance,” said B. Prasanna, group executive and head of global markets at ICICI Bank. 

Also, given that the macro context in India is slowly changing with both growth and inflation surprising on the upside, the RBI might not be comfortable with such deeply negative real rates, according to Prasanna.  

The one-year treasury bill rate below the overnight repo rate meant that the system has more liquidity than what would be required for an effective monetary policy signal to pass through, say economists. Besides, such low rates are not good from the system stability point of view either. 

“These kinds of rates encourage increased leverage.  All kinds of leverage build up when rates are low, and that could lead to deep problems when rates go up,” said Gaurav Kapur, chief economist at IndusInd Bank.  

“At some point, sooner than later, the central bank will have to withdraw this excess liquidity. May be they can start with rolling back their cash reserve ratio (CRR) relaxations even before June deadline,” said Kapur.  

In response to the Covid crisis, RBI on March 27 had cut CRR by 100 basis points to 3 per cent, and told banks that they can maintain the daily CRR at 80 per cent of the requirement, instead of 90 per cent earlier. This one-time relaxation was allowed till June. The CRR cut alone released close to Rs 1.4 trillion in the banking system.  

The central bank is unlikely to change its policy stance from accommodative to neutral, any rate hike to control inflation is also out of the question for now. Interestedly, the bond market is so used to the easy liquidity, that they won’t treat the central bank’s efforts to mop liquidity kindly.  

If the central bank attempt to bring short term rates back up, it risks giving a hawkish signal to the market, which may “undo its own stated accommodative stance at a juncture where the recovery is not fully secured," Prasanna said. 

A non-disruptive way of achieving this would be to take out the excess liquidity generated through foreign exchange intervention through short term bills issued under the Market Stabilization Scheme (MSS), in which even non-bank participants would get to deploy their surplus liquidity, experts say. 

Another, more non-conventional move could be to allow access mutual funds and insurance companies to the RBI reverse repo window. The central bank, for the time being, can also indulge in forex swaps with banks, in which it would give dollars to absorb excess liquidity. Recalling back money given under long term repo operation (LTRO), though, hasn’t been successful so far as banks seem to be reluctant to give back their already deployed cheap funds. 

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