The minutes of the Monetary Policy Committee (MPC) meeting released by RBI on June 22 indicate that price stability has been prioritised over growth. But MPC members also do not want to lose the focus on growth. As the RBI Governor has remarked in this statement in the minutes: “Our fight against inflation is not yet over. We need to undertake forward-looking assessment of the evolving inflation-growth outlook and stand ready to act, if situation so warrants”.

The RBI Governor, in his June 8 statement, also noted that robust government capital expenditure “is expected to nurture investment and manufacturing activity”. This pointed to the higher capital expenditure provisioned in the Union Budget, at 3.32 per cent of GDP in the 2023-24 Budget on top of an allocation of 2.85 per cent in 2022-23 (calculated from the actual data released by the Controller General of Accounts, CGA).

The current juncture demands a close watch on liquidity management, which (along with the fiscal deficit) is the key to managing the inflation-growth dynamic in the economy. In the words of the RBI Governor, “We will continue to remain agile and flexible in managing liquidity through two-way operations. We do recognise that durable price and financial stability are mutually reinforcing and necessitate greater policy focus at the current juncture.”

From the foregoing, we can construe a twin problem relating to: (a) the liquidity management operation of the RBI in support of the monetary policy stance; and (b) financing of the fiscal deficit in the context of higher allocation of capital expenditure in the Budget. There is an undertone of friction between the two.

Technically, there are three aspects in liquidity management: (a) the operating framework; (b) drivers of liquidity; and (c) management of liquidity. The operating framework is guided by the Liquidity Adjustment Facility (LAF) corridor wherein the policy repo rate (PRR) is the key rate which signals the overnight rates and the objective is to keep the policy repo rate in sync with the weighted average call rate (WACR), which is the operating target of RBI’s monetary policy.

Currently the PRR stands at 6.5 per cent. Conceptually, when the system is in deficit, the WACR is traded higher than PRR and in the surplus liquidity situation the reverse happens. Currently, the system is in surplus mode. For example, according to the latest data released by the RBI, during the period June 5- 11, the surplus liquidity (net absorption by RBI) varied within the range of ₹2,929 crore and ₹1,31,455 crore.

Reflecting the surplus liquidity situation (net absorption by RBI) during April- June (June 11) 2023, the spread between PRR and WACR on an average varied within the range (-) 0.03 bps and 0.09 bps. According to the RBI Annual Report (Paragraph III.19 and page 102), the WACR traded 3 bps above PRR (on an average) in H2 of 2022-23 in contrast to 27 bps below the PRR in H2 of 2022-23.

The two other instruments in the LAF corridor are Marginal Standing Facility (MSF) as the ceiling above the repo rate (6.75 per cent) and Standing Deposit Facility (SDF) as the floor below the repo rate (6.25 per cent). Thus, the LAF corridor is currently symmetric around the policy repo rate with the width of 25 bps for the ceiling (MSF) as well as the floor (SDF). It may be noted that RBI activated the SDF on April 8, 2022. With the institution of SDF as a non-collateral instrument, the RBI strengthened the operating framework of monetary policy. It is important to note that access to SDF is at the discretion of banks in contrast to other instruments such as repo/reverse repo open market operations which are at the discretion of the RBI.

The major drivers of liquidity are: (a) currency in circulation; (b) net forex purchases/sales by RBI; (c) government cash balances with RBI; and (d) excess reserves maintained with RBI. Translating this to components of reserve money and sources of reserve money (a) and (d) will broadly constitute the components and (b) and (c) will largely constitute the sources. According to the latest data released by RBI, as on June 9, in the component side currency in circulation constituted 60.9 per cent of the total increase in the reserve money and increase in net foreign exchange assets of RBI accounted for 86.3 per cent of the total reserve money. Thus, the surplus liquidity was mainly driven by an increase in foreign exchange from the asset side.

Money stock

Another important aspect is the deposit of the ₹2,000 denomination bank notes in the banking system effective from May 23. The RBI Governor mentioned that around 50 per cent of the total bank notes have come back to the system and 85 per cent of them as deposits. As per RBI’s money stock data, the growth in time deposits on y-o-y basis was 11.5 per cent as on June 2, as against 8.1 per cent in the corresponding period of the previous year.

Currently, the RBI absorbs surplus liquidity through three instruments: (a) variable rate reverse repo (VRRR); (b) SDF; and (c) open market sale. According to the RBI Annual report 2022-23 (paragraph III.18, page 101), the daily absorption under the SDF during 2022-23 averaged ₹1.5-lakh crore while the amount absorbed through VRRR auction averaged ₹1.4-lakh crore. During the Q1 of 2023-24, the absorption of surplus liquidity was predominantly by SDF. It is pertinent to mention that the absorption of liquidity through SDF and VRRR has a balance sheet effect in the outflow of RBI’s income to the banking system.

We explore further the surplus liquidity position from the angle of financing of the fiscal deficit based on the CGA data. We observed a disturbing trend in three items: (a) deposit of cash balance of the government with the RBI; (b) investment of surplus cash; and (c) ways and means advances (WMA) from the RBI. The government has taken recourse to WMA amounting to ₹48,677 crore and, at the same time, the government cash balance with RBI has increased to ₹10,200 crore and government has invested its cash surplus aggregating ₹35,352 crore. This trend reveals that (a) WMA from RBI has been used to finance fiscal deficit and (b) the government has over borrowed and invested the surplus cash.

Furthermore, a perusal of April 2023-24 of CGA data shows that the outstanding WMA was of ₹48,677 crore was cleared by RBI in April 2023. This shows the WMA was used by the government as a resource to finance the fiscal deficit.

This is against the stated objective of WMA as the purpose of WMA is to meet temporary and sudden mismatches in the government cash flows. This development presents weak cash management of the government. This has adverse repercussions for the RBI’s debt management, liquidity management and overall monetary management.

There is a need for further strengthening of the monetary-fiscal interface. This requires not only strict monitoring of the liquidity position by the RBI but also of the financing pattern of the fiscal deficit by the government as the continued and prolonged surplus/deficit cash position by the government with the RBI has adverse repercussions in the liquidity management of the RBI.

The writer is a Professor at the Gokhale Institute of Politics and Economics, Pune, and a former central banker. Views are personal. Through the Billion Press