Moving From Overindulgence To Indulgence


As we head towards the monetary policy review in October, there is some good news and some not so good.

Inflation, which was above the central bank’s target range, moderated and stabilized, albeit at high levels. This is the good news. On the other hand, there are unprecedented levels of liquidity in the banking system and concerns about the potential adverse effects of this situation are increasing. This is the less good news.

It is these two questions, as well as the assessment of the disappearance of risks to growth, which form the backdrop for the next monetary policy review.

Liquidity, Liquidity Everywhere …

Before we talk about what can and should be done, let’s first understand the nature of this liquidity. The current liquidity of the system is about 7% of the net demand and term liabilities, or roughly, of the deposits of the banking system.

This liquidity can be attributed to two elements: “discretionary” policing operations and other “stand-alone” factors. Autonomous factors typically include currency leaks, changes in foreign currency holdings, and the volume of government deposits. On the other hand, discretionary liquidity arises from the operations of the central bank, including the purchases of bonds from open market operations, the modification of minimum reserves, etc.

Amid the pandemic, it was necessary for the RBI to inject liquidity into the banking system to prevent the markets from freezing, revive market activity and restore investor confidence. More importantly, to ensure adequate flows to sensitive sectors that lacked liquidity, the RBI needed to incentivize banks, which it did through innovative tools such as targeted long-term repo operations.

All of this added “discretionary” liquidity.

Meanwhile, contrary to the popular belief that global crises cause exits from emerging markets, the post-Covid period has been characterized by massive inflows into emerging economies. This was largely due to liquidity created by central banks of developed countries (which are exporters of capital) coupled with massive counter-cyclical budget spending. On top of that, India has seen its trade balance shift from a deficit to a surplus in the midst of the crisis.

As the RBI intervened to prevent an instinctive appreciation of the rupee, liquidity was added.

There has also been a significant shift in focus behind the RBI’s intervention in the markets.

Conventionally, bond purchases are made with the aim of creating liquidity in the financial system in line with the needs of the economy. A byproduct of such a transaction is the softening of bond yields due to the purchase of bonds by central banks.

This time around, the causality has changed. The central bank’s main objective is to keep bond yields at desired levels by purchasing sovereign bonds, while liquidity creation is its by-product.

The Rs 12-Lakh-Crore question

The question now is how to deal with this record level of liquidity.

First, we have to accept that it is extremely difficult to take a call on the length or potential impact of the future wave of Covid. Waiting for a clear signal on this, however, could become costly. We may have to live with the virus for a long time and the pandemic could slowly become endemic.

Therefore, it is better to take preventive measures to moderate the excess, well before the start of the tightening. Think of it as removing excess fat from the body before it becomes toxic.

Right now, the RBI is reassured that this credit drawdown is low as companies reduce their debt. We are far from overheating. But that does not guarantee that these risks will not appear in the future.

Likewise, this unprecedented level of system liquidity in a context of weak credit demand could distort risk assessment and product pricing in the market. Cheap short-term rates also amplify abnormal demand in other segments of the financial markets. The IPO financing market is a good example.

What can RBI do to solve these puzzles?

Since the MPC is empowered to make decisions on the stance of monetary policy and the repo rate, it is likely to stay in cruise mode for some time.

There are basically two options on the RBI’s menu right now: restricting the money supply; increase the cost of money; or do both.

To mop up sustainable liquidity over the long term, the RBI can issue bonds under the Market Stabilization Scheme (MSS). However, it is not clear if this tool can be used now since the central bank has also had the option of activating a permanent deposit facility where excess liquidity can be absorbed at rates below the repo rate. The RBI has yet to use this window and a key complicating factor here is the rate at which this window will absorb liquidity.

More importantly, the impact of any MSS bond issue on benchmark returns will be severe.

If these options are excluded, then the RBI can stop buying bonds under the G-SAP scheme to restrict the money supply. But the central bank can think twice before doing so, as these purchases reassure the market and keep long-term interest rates from rising.

The other option is for the RBI to regularly sterilize liquidity and raise short-term rates in a phased manner. It can do this by using longer-term floating rate reverse repo auctions with a duration of 30 to 56 days. This will block the liquidity of the system, even if the lengthening of the duration will push very short-term rates towards the repo rate of 4%.

Tactically, the RBI could consider auctioning very long term 9 to 12 month floating rate repurchase agreements. However, if banks expect rates to rise during this period, they might not be inclined to tie up funds for such a long period. This could be resolved by allowing a rollback of this transaction.

A complementary action would be to start to normalize the corridor between the repo and reverse repo corridors towards 25 basis points in small steps. It is currently 65 basis points.

Each of these RBI moves could run into a “signal extraction” problem – that is, the central bank might see it as normalization while the market might see it as tightening. The RBI can mitigate this problem with forward guidance that promises accommodative monetary policy until the recovery is firmly entrenched.

The crisis has taught us that central banks must be flexible. This, however, is true both during the crisis and in the post-crisis phase.

Restoring normality is a challenge, but it is the key. Otherwise, market players develop an unhealthy dependence on the central bank and demand increased flexibility or support. This, in turn, could create unrealistic expectations on the part of the central bank and damage its credibility.

Soumyajit Niyogi is Associate Director at India Ratings & Research – A Fitch Group Company. The opinions expressed here are his own and do not reflect those of the organization.

The opinions expressed here are those of the author and do not necessarily represent those of BloombergQuint or its editorial team.


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