The pressure on banking system has further been aggravated by the problems faced by a section of the Indian mutual fund industry—the so-called liquid funds which invest in money market instruments. Some of these funds have invested in short-term commercial papers (CPs) and certificate of deposits (CDs) issued by non-banking finance companies (NBFCs) and in real estate companies to earn high returns. They have also invested in asset-backed securities and bought pools of retail loans in the form of truck finance, car loans, etc. These securities, known as pass through certificates or PTCs, offer higher interest but are illiquid and the funds bear the default risk. Banks were parking their excess money in these funds but now, facing a liquidity crunch, they are withdrawing money from such funds. This is shrinking the size of the funds and, at the same time, drying up resources for firms that were raising money through CPs and CDs. They are now turning to banks for funds, adding to the liquidity pressure.
In August, liquid funds were managing assets worth Rs89,000 crore, about 18% of total assets under management of the Indian mutual fund industry. According to industry estimates, in the past one week, Rs30,000 crore has been withdrawn from liquid and other debt funds, and in the past three months, the withdrawal could be as much as Rs1 trillion.
Finally, the growing mistrust among global banks and their refusal to lend to each other is also affecting domestic liquidity. Most large Indian banks, both state-run as well as private ones, have an overseas presence. The aggressive ones have been building assets overseas by rolling over their liabilities, raised from the inter-bank market. But these money lines are now fast drying up and it is difficult to replenish them as overseas banks are not rolling over the credit any more even though the London inter-bank offered rate (Libor), an international benchmark for interest rate, is soaring. So, if an Indian bank faces a liquidity crunch abroad, it is now being forced to borrow from India, convert the money into foreign currency, and then quickly export the funds to support the bank’s overseas operations.
Last Friday, the government cancelled auctions of two bonds slated to raise Rs10,000 crore but, sooner or later, it has to enter the market as part of its borrowing programme (around Rs39,000 crore) is left to be completed this fiscal year. So, the pressure on liquidity can only rise. How does RBI tackle the crisis? Apart from cutting CRR, it has been infusing money through its repurchase or repo window every day. Under this arrangement, banks borrow from RBI at 9%, offering government bonds as collaterals.
In October, on average, RBI has been infusing about Rs75,000 crore daily into the system.
Theoretically, RBI can cut CRR to zero in stages and the seven and a half percentage point cut—the current level of CRR—can infuse Rs3 trillion in the system. This allows RBI to sell about $60 billion in the foreign exchange market, at the current rupee-dollar exchange rate, to support the local currency. This is little more than 20% of the country’s foreign exchange reserves and double of what RBI has sold since May.
MSS bonds can also be unwound to create liquidity. The outstanding MSS bonds are worth Rs1.73 trillion. Unwinding these bonds will release liquidity not for the entire system but for those banks that had bought the MSS bonds.
However, RBI cannot do this because Indian banks are required to invest certain portion of their deposits in government bonds known as SLR (statutory liquidity ratio— or the ratio of their funds that banks are required to maintain in liquid instruments) securities.