A sudden liquidity crunch that has gripped the Indian financial system is likely to force the Reserve Bank of India (RBI) to act sooner rather than later, as neither the Indian central bank nor the government wants the current uncertainty to continue in the money market, which may lead to a spike in interest rates on various market instruments, bank deposits and government bonds.
It’s going to be a high-wire balancing act for RBI: it cannot afford to ease its monetary stance and flood the financial system with liquidity at a time when industrial output is rising rapidly and core inflation—which excludes volatile food and fuel prices—is accelerating.
A section of the market believes that RBI may not wait till 27 July, when it reviews its monetary policy, and lace its liquidity-easing measures with a small hike in policy rates.
Liquidity-starved banks have been raising an average Rs45,000 crore from RBI every day and the crunch will intensify from next week with an outflow of about Rs25,000 crore from the financial system on account of firms’ payment of advance tax. Besides, another Rs38,500 crore will flow out of the system to fund licence fees for broadband wireless access spectrum.
This means the money market will see a shortfall of at least Rs1 trillion from next week—and nobody knows how long the crunch will continue.
If RBI does not act to ease liquidity immediately, the government needs to step in and spend aggressively to bring back the money into the system. The usual extent of government spending in June and July is not enough to take care of the shortfall of liquidity in the system.
Indian corporations pay income every quarter on their projected profits. This time around, the amount of tax payment is around Rs35,000 crore, but the actual cash outgo could be in the range of Rs25,000-28,000 crore as typically this outflow is matched with some government spending that brings money into the system. Corporation taxes were paid on 15 June and will flow out of the banking system on 17 June, as banks retain the money for a day.
To aggravate the tight situation, RBI will auction two government bonds to raise Rs11,000 crore on Friday. Between next week and end-July, another Rs68,000 crore worth of government bonds will be auctioned. With about a trillion-rupee shortfall, how will the banking system support such a heavy government borrowing programme and also meet the credit demand of corporate and retail consumers?
One way to ease pressure is by cutting the cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with RBI. Currently it is 6%. A one percentage point cut in CRR will infuse about Rs45,000 crore liquidity in the system, but RBI cannot do this as a cut in CRR will signal a reversal of its policy stance.
What it can possibly do is buy back bonds from the market under its so-called open market operations. On 2 July, a government bond worth Rs15,515 crore is due for redemption. Another redemption, worth Rs34,000 crore, is slated for 28 July. RBI can offer to buy back these bonds from the banks. Essentially, this will mean a slightly premature redemption of the bonds and an infusion of Rs39,515 crore into the system.
RBI can also postpone part of the government borrowing programme in June and July to take the pressure off from the system. The government plans to borrow Rs4.57 trillion in the current fiscal to bridge its deficit and 63% of this amount is slated to be raised in the first six months of the year, but with money coming from sale of telecom licences, the government would not need to borrow so much so quickly. In May, nine successful bidders for 3G spectrum had paid Rs67,719 crore to the government for the 22 telecom circle licences on offer, far more than the Rs35,000 crore of revenue the government had budgeted for from the third-generation and wireless broadband auctions.
It seems that RBI did not anticipate the severity of the liquidity crunch in May-end, when it allowed commercial banks to borrow up to half a percentage point of their deposit base till 2 July.
The liquidity thus generated, around Rs22,500 crore, can be used to meet credit demand. Since the crunch will continue beyond 2 July, RBI may extend this by a few weeks till liquidity returns to the system, but this concession will not make a significant difference as it will not create liquidity, but will merely allow commercial banks to borrow extra money from the central bank.
RBI has been exploring other ways, too. One of the suggestions has been to go for a staggered-payment government bond auction. A few corporations have done this, but this route was never explored for sovereign-bond auctions. Had the central bank accepted this suggestion, it would have asked banks to part pay, say 10% of a bond sale now, and the rest a few months later. In this way, the government can lock the price of the bond today and raise the money later. The yield on the benchmark 10-year bond continues to be around 7.60%, but it may rise later.
Another option before the government could have been not accessing the broadband spectrum auction money now. It could have been kept in a special account, say with the State Bank of India, and drawn down later, when the government needs the money.
Many expect RBI to hike its policy rates by a quarter percentage point each simultaneously with the liquidity injection measures. The repo rate, or the rate at which it injects liquidity, is 5.25% now and the reverse repo rate, or the rate at which it sucks out liquidity, is 3.75%.
Since the liquidity is tight now, the repo rate has automatically become the anchor rate. This means, the policy rate has gone up by 1.5 percentage points—from 3.75% to 5.25%—without any formal rate hike.
Since nobody is certain on how long the current liquidity crunch will continue, this will lead to a sudden spike in various rates. No regulator can be comfortable with this. Which is why, after ensuring appropriate liquidity in the system, RBI is expected to opt for a quarter percentage point rate hike. This will be in conformity with its gradual approach to a tight money policy as otherwise a sudden spike will dampen economic growth. The central bank can do this now. Or else, wait for July-end when it announces its quarterly review of the monetary policy. Many believe that will be a bit late as the high industrial growth and wholesale price inflation demand decisive and fast action from RBI.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at email@example.com