Abhay rubbed his eyes in disbelief. This is something he has not seen in his 17-year career in the Indian debt market. A primary dealer who buys and sells government securities, Abhay, who didn’t want his last name used, was in his office Friday watching the trading screen of the Clearing Corporation of India Ltd (CCIL), which flashes buy and sell quotes of banks, mutual funds, insurance firms and corporations lending and borrowing overnight money. Just 15 minutes before the market closed, the trading screen was flashing a “quote” by a commercial bank that wanted to park its excess funds worth Rs175 crore at the interest rate of one paisa!
Since it was a Friday, the money on offer was for three days (to be returned on Monday). At 0.01% annual interest rate, Rs175 crore would have fetched the lender a princely sum of Rs1,440 for three days. Even then, there was no taker. “No one was even interested in free money,” says Abhay.
Last week, India became China and Japan rolled into one, combining an 18-year high economic growth rate and historic low overnight rates. However, the one-paisa interest rate did not last long, as the Reserve Bank of India (RBI) stepped in late Friday evening to stamp out excess liquidity and push the rates up. By the time you read this column on Monday, the overnight rates have probably gone back to the level of 5-6%.
Why did RBI take so long and allow an avalanche of money supply to bring down overnight rates to such an absurd level? After all, over the past year, it has raised its policy rate five times to 7.75% and sucked out liquidity by raising the cash reserve that commercial banks need to keep with RBI. As a result of its tight money policy, the overnight rate rose to 80% in the last week of March.
Let’s look for answers to two key questions. First, where did the surfeit of liquidity come from? And why did RBI allow the Indian financial system to flirt with excessive liquidity in the second half of May after keeping a tight leash on money supply for the past few months?
One way of measuring the excess liquidity in the system is money that banks park at RBI’s reverse repo window every day. RBI sucks out excess funds through this window at 6% and infuses money, when the banks need, through its repo window at 7.75%. On an average, the repo window saw banks pouring in close to Rs51,000 crore daily last week. Had RBI accepted their offerings at 6%, the overnight rate would not have crashed. However, the central bank does not absorb more than Rs3,000 crore daily from the banking system. So, those banks that have excess money lend to other banks at the overnight market as well as mutual funds, insurance firms and corporations at the CCIL trading platform. With so much of supply and no demand for money, the rates plunged.
But where did the money come from? The primary reason behind the sudden surge in money supply is RBI’s return to the foreign exchange market to prevent the excessive rise of the rupee. The rupee, which was trading at Rs44.30 to a dollar in January, rose by about 9% to trade at Rs40.52.
Had RBI not bought dollars from the market in the past two weeks, the local currency would have settled at close to Rs40 to a dollar level. The central bank allowed the rupee to appreciate to the level of Rs44.50 to a dollar, but anything higher than this seems to be making it distinctly uncomfortable. If the foreign exchange dealers are to be believed, the central bank must have bought at least $2 billion from the market. For every dollar it buys, an equivalent amount of rupees flows into the system. So, around Rs8,400 crore (depending on at what price RBI has bought dollars) was added to the rupee liquidity in the past fortnight. Besides, the redemption of some old government bonds that infused about Rs20,000 crore.
RBI’s decision to sell government bonds and treasury bills did not surprise the market as it was expecting even harsher measures, such as a hike in the banks’ cash reserve ratio to drain excessive liquidity. The surprise was in RBI’s inaction in the past two weeks. It could have announced such measures earlier. For instance, it could have sucked out liquidity by selling treasury bills under the monetary stabilization scheme (MSMS), an arrangement that was put in place in 2004 to drain excess liquidity. Under this arrangement, RBI can issue treasury bills and bonds up to Rs1.1 trillion. Till last week, the outstanding MSS was Rs88,802 crore.
Then why did it allow the overnight rate to drop to such an absurd level? One possible explanation could be that by bringing down the short-term rates (apart from overnight money, short term treasury bill yields also went down sharply), RBI was discouraging the flow of hot money into the system. Higher interest rates and appreciating currency are a lethal combination to attract hot money. But if this is the case, the Indian central bank should have continued to stay away from the money market. By allowing the short-term rate to plunge for a fortnight, RBI only added volatility to the market, which central banks are not expected to do.
Early last week, I had asked RBI deputy governor Rakesh Mohan whether there was any change in the RBI policy. Mohan came out with an emphatic “No”. Indeed, there is no change in the RBI’s stance. But why did it take a fortnight to demonstrate this? I am sure there are reasons and we do not know them yet.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai Bureau Chief of Mint. Send comments to firstname.lastname@example.org