Liquidity management in the limelight

The RBI’s liquidity management has once again hogged the limelight in the recent period. It would continue to remain under stakeholders’ vigilance at least for the next 3-6 months. Many analysts are intrigued as the stance of monetary policy — ‘calibrated tightening’ and large injection of liquidity through Open Market Operations (OMO) appear to be baffling.

Central banks typically implement monetary policy through appropriate liquidity management on a day-to-day basis. Liquidity management ought to be consistent with the stance of the monetary policy and critical in aligning the operating target — the weighted average call money rate in case of India — close to the policy rate.

The recent divergence between the India’s stance of monetary policy and liquidity management seems to have complicated RBI’s communication, besides obfuscating financial analysts. The evolving liquidity condition needs introspection and alternative solutions.

The Monetary Policy Committee (MPC) decided to shift the RBI’s monetary policy stance from ‘neutral’ to ‘calibrated tightening’ in October 2018 under compelling circumstances. Rise in the crude oil prices in the international market and large depreciation of rupee against the US dollar, following outflows of portfolio investments from both debt and equity segments, overwhelmed MPC Members to quickly change the stance.

As the real policy rate was already high, the RBI could not hike the repo rate in October notwithstanding great temptation to do so due to large capital outflows and rupee depreciation amidst inflation expectations above the target. Two rounds of consecutive repo rate hikes earlier in June and August could not impart exchange rate stability.

Large interventions in the forex market were needed much before October to mitigate depreciating pressures on the rupee. During March-September 2018, the RBI lost about $24 billion while the loss was about $31.8 billion during March-November 2018. This has resulted in sucking out more than ₹1.5 trillion of rupee liquidity from the market by September and ₹2.2 trillion by November 2018.

Liquidity injection

Enduring shortage of liquidity is typically managed through permanent injection of liquidity through OMO failing which there would be undue pressure on the repo window under liquidity adjustment facility (LAF). During first half of 2018-19, OMO purchases were limited to ₹50,000 crore.

Had there been enough OMO purchases before October, sucking of liquidity through forex operation would have been largely offset. As against the liquidity shortage of over ₹2 trillion, the size of OMO purchases during the current year so far have been ₹1.36 trillion. For December 2018, another ₹40,000 crore OMO purchases have been scheduled.

As purchases under OMO are expected to continue, at least till March 2019, SLR has been reduced so that OMO purchases would be smooth going forward.

During 2018-19, credit cycle turned around coinciding with large capital outflows. Moreover, deposit growth has been much below the credit growth during the current year leading to structural shortage of liquidity. Pick-up in credit together with forex market intervention contributed significantly to the systemic liquidity shortage. Monetary policy documents did not clearly communicate as to how the excess liquidity in the post-demonetisation period has suddenly turned tight. Nor do they attempt to provide sufficient durable liquidity to the market before October despite forex operations impacting liquidity condition in a big way.

Liquidity management is a complex process. However, it can be simplified by suitable communication. The RBI should be committed to manage structural liquidity through durable instrument and frictional liquidity through LAF, apportioning between these two modes would not be difficult to arrive at.

The issue still remains unresolved as to whether OMO (purchases) is the only way to inject durable liquidity into the market. Is there any adverse effect of large OMO purchases in a single year? If the RBI continues to purchase G-Sec at the rate of ₹40,000 per month till March, total OMO purchases in 2018-19 would be ₹2.96 trillion, more than 64 per cent of the net market borrowing of the government. If repo outstanding would be taken into account, monetisation of debt in 2018-19 would be still higher.

This would have significant impact on G-Sec yield. The yield on 91-day Treasury bill has come down from 7.2 per cent in October to 6.8 per cent by early December 2018. It would not be surprising to anticipate the T-Bill rate to come down below the current repo rate due to large OMOs.

The bank factor

What would happen to banks’ profitability if G-sec yield falls below the deposit rate? Eleven public sector banks and one private sector bank, currently under prompt corrective actions, would have to bear the biggest brunt, as they face lending restrictions. Regulatory restrictions on these banks would reduce their profit margin in a big way except some valuation gains.

Alternative options before the RBI are: (a) reduce CRR, at least by 50 basis points; (b) purchase dollars from the market if exchange rate falls below ₹70 per dollar; (c) provide comfort to the market by reverting to neutral monetary policy stance in February 2018; and (d) reduce repo rate by 25- 50 bps by April 2019 as CPI inflation rate is expected to remain benign around 4 per cent in the medium term.

The CRR is perceived to be outside the remit of the MPC. However, as a part of liquidity management, the RBI can kill two birds in one stone by cutting CRR outside the policy cycle. Reserve money expansion would be less through cut in CRR rather than OMO purchases to provide enduring liquidity. Monetisation of debt in a single year can be reduced considerably.

Moreover, it will be a great relief for banks to earn some return from the cash released through CRR reduction. Given the deposit base of ₹120 trillion, a CRR cut of 50 bps would release about ₹60,000 crore, which would supplement durable liquidity injection by OMO.

The author is currently a Visiting Fellow at IGIDR and former Principal Adviser and Head of the Monetary Policy Department, RBI.