A one and a half percentage points cut in banks’ cash ratio (CRR), which defines the amount of cash that commercial banks need to keep with the Reserve Bank of India (RBI), infused Rs60,000 crore into the liquidity-starved Indian financial system on Saturday.
There have been occasions in the past when CRR was cut by more than one and half a percentage points. For instance, in November 2001, it was cut by one and a three-quarter percentage points to 5.75% and in July 1974, the cut was even sharper—two percentage points, to 5%. But in its 73-year history, RBI has never announced a second round of CRR cut even before the first cut takes effect—something it did last week.
This shows the seriousness with which the Indian central bank is viewing the liquidity crisis. Till recently, the system had plenty of money. In fact, RBI had to raise CRR by one and a half percentage points in stages since April to drain excess money that was stoking inflation.
Where has all the money gone?
What is the root of the sudden liquidity crunch?
The main source of money in the system in the past two years has been RBI’s dollar buying. The seemingly unending dollar flow pushed the level of the local currency to 39.20 early this year. An appreciating rupee hurts the competitiveness of exporters as their real income in rupee term goes down. So, RBI was buying dollars from the market to stem the rise of the rupee and, for every dollar it bought, an equivalent amount in rupees was injected into the system.
Action time: Inside the RBI regional office in New Delhi. With $284 billion in foreign exchange reserves, RBI can afford to be bold in its currency management strategy, now inseparable from liquidity management. Harikrishna Katragadda / Mint
As a result of this, India’s foreign exchange reserve rose to a record $316 billion (Rs15.39 trillion) in May. At the same time, the rupee liquidity in the system increased phenomenally. The excess liquidity was mopped up by the banking regulator through a series of hikes in CRR and floatation of special bonds under the monetary stabilization scheme or MSS.
Under this scheme, RBI floated dated securities as well as short-term treasury bills which were not part of the government’s annual borrowing programme to raise money to bridge the fiscal deficit.
RBI is not buying dollars any more as the supply has dried up. It is, in fact, selling dollars to protect the sharp erosion in the value of the local currency as a weak rupee increases the cost of import and adds to the inflation.