By raising the cash reserve that commercial banks are required to keep with the Reserve Bank of India (RBI) by 0.50% and removing the cap on the central bank’s daily absorption of liquidity from the system, RBI governor Yaga Venugopal Reddy has won the confidence of the market. However, bankers and bond dealers are far from convinced about the efficacy of this move as there is no sign of easing capital inflows. Since the government is unlikely to consider capital control measures to deal with the flows, RBI seems to have no choice but to continue with the familiar formula of managing the “impossible trinity”—interest rates, exchange rate and inflation. The situation is tricky as the regulator doesn’t want the rupee to strengthen beyond 40 to a dollar, and wants to maintain the overnight rate at 6% and keep the inflation rate at 5% or even lower.
These three are interlinked. RBI has been buying dollars from the market to keep the rupee level at 40 to a dollar. If it does not do so, an oversupply of dollar will push down the value of the greenback vis-à-vis the local currency further. Since April, the rupee has already appreciated by over 8% against the dollar and RBI does not want it to appreciate further as it will hurt India’s export competitiveness. The liquidity swells as with every dollar RBI buys, an equivalent amount of rupee flows into the system. This drives down the overnight rate. An oversupply of money also fuels inflation.
Since Reddy has raised the cap on liquidity absorption, RBI will start draining oversupply of money from the system from Monday. The overnight rate, which was veering around the near-zero level, has already risen. However, Reddy might be a fighting a losing battle as bankers foresee a higher capital inflow pushing up the value of the rupee to 39 and even 38.5 in the next one year. So another round of hike in banks’ cash reserve and even interest rate cannot be ruled out as the tiger of inflation has not yet been caged.
Till such time, RBI can fine-tune its liquidity adjustment facility (Laf) that it has been using to signal interest rates. Laf was introduced in June 2000, marking a migration from direct instruments of monetary control such as bank rate and banks’ cash reserve kept with RBI to indirect instruments. Bank rate is the rate at which banks theoretically can draw down refinance from RBI. Till the introduction of Laf, it was the main signal rate. Laf operates through repo and reverse repo windows of the central bank, creating a corridor for all short-term interest rates.
RBI injects liquidity when the system runs dry through its repo window and absorbs surplus liquidity through its reverse repo window. The repo rate is 7.75% and reverse repo rate 6%. This essentially means overnight rates should move between these two rates. Ideally, in a liquidity-surplus situation—as is the case now—reverse repo is the policy rate and when the liquidity dries out, repo becomes the signal. However, too much of liquidity—generated out of RBI’s dollar buying as well as increased government spending—has made the corridor meaningless. Between March and now, RBI has not been absorbing beyond Rs3,000 crore of excess liquidity at 6%, forcing banks to park their money at the overnight market and driving down the rates to abnormally low levels.
The lifting of the cap on RBI’s absorption of excess liquidity has brought back sanity to the overnight market rates but if Reddy wants to maintain the credibility of Laf, he may have to take a closer look at the liquidity phenomenon and use different instruments to absorb different blocks of liquidity.
The two primary ingredients of liquidity in the Indian banking systems are government spending and capital flow. Even capital flow can be divided into two parts—one is of enduring nature such as foreign direct investment and another that can flow back or hot money. The entire portfolio investment made by foreign institutional investors (FIIs) is not hot money. FIIs would not en masse leave the Indian market overnight as such a move will pull down the market, making them the worst sufferers. About 30% of the capital flow can be termed as hot money. This liquidity can be absorbed through short-term bonds under the special scheme devised by the government. This scheme can absorb up to Rs1.1 trillion but the limit has to be raised soon with the nod of Parliament as close to Rs1 trillion worth of bonds have already been issued. RBI’s reverse repo window can be exclusively used to iron out volatility created by excess government spending. Essentially, RBI must remove the liquidity sloshing around the system and use different instruments to do this.
Ultimately, it can move towards a single policy rate on the line of the US Federal Reserve. Narrowing the Laf corridor by getting the repo and reverse repo rates closer to each other can be the first step towards this goal. Creation of a term money market and making the rupee full float are, however, the two essential preconditions for a single policy rate at which a central bank absorbs as well as injects liquidity.
Once India embraces capital account convertibility, the monetary policy will see a radical change. Meanwhile, RBI can encourage commercial banks to show some smartness in managing their cash flows. By absorbing liquidity at a pre-determined rate and for a pre-determined maturity, RBI has virtually turned a cash manager for the banks. It can absorb money at variable rates and for variable maturities. For instance, instead of taking money for one day, RBI can always go for one-week or even a fortnight reverse repo deals. Similarly, it can pay variable rates, depending on the situation. These little surprises will make the policy more effective and commercial banks will stop taking the regulator for granted.
(Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to firstname.lastname@example.org)