One-minute guide: Four tools to absorb excess liquidity from the economy
CRR is the percentage of a bank's time and demand liabilities that needs to be kept as cash with RBI
Last week, the Reserve Bank of India (RBI) announced a rare measure to increase the incremental cash reserve ratio (CRR) to 100% of net demand and time liabilities raised between 16 September and 11 November 2016.
The objective is to absorb the excess liquidity in the system, some of which got created due to the ban on the existing currency notes of Rs500 and Rs1,000. Although the cut off date of 11 November is only two days into the deposit rush seen after the demonetisation move, deposit accretion for banks was on the rise in the first half of September quarter itself.
Cash reserve ratio (CRR)
CRR is the percentage of a bank’s time and demand liabilities that needs to be kept as cash with RBI. It is one of the tools that the central bank uses to control the total liquidity in the banking system.
Currently, the CRR is at 4%. A high CRR means banks have less to lend and, hence, curbs liquidity. A low CRR does the opposite.
The present situation is one of excess liquidity by an extraordinary margin hence, the incremental CRR has been put at 100%.
There are some other measures that the RBI can use to reduce liquidity.
Reverse repo auctions
This usually helps in managing daily excess liquidity. It’s a facility where banks can earn on their excess funds through the RBI in exchange for government securities.
At present, the interest paid by the RBI on this transaction is 5.75%.
The reverse repo window is available to scheduled commercial banks and to primary dealers.
At present, this is also what the RBI is relying on to absorb the excess liquidity. For example, according to data from Bloomberg, on 25 November, around ₹ 5.2 trillion was outstanding in the reverse repo window.
However, by various expert estimates, the RBI has only around Rs7 trillion worth of g-secs to help in taking in the deluge of liquidity.
The amount deposited into banks is expected to exceed Rs10 trillion by the end of December. Therefore, it is unlikely that the reverse repo window will be enough.
Open market operations (OMO)
This is another format used to buy or sell government securities to manage liquidity. In the current situation, g-secs would have to be sold to banks to take up the excess.
However, here as well, supply is a constraint given the extraordinary amount of liquidity in the system.
Unlike the reverse repo window, OMO is a more durable, long-term action. Reverse repo transactions can be undone with banks giving the securities back to the RBI, which is not possible with OMO.
Market stabilisation scheme
In this case, fresh issuance of bonds is made to soak up liquidity.
Operationally and financially, this is a costlier option to have. The bonds transacted in the market stabilisation scheme are also g-secs but issued specifically for a particular situation with approved from the government.
Comparison
Compared to the CRR change—which is a quick, temporary, less costly and a more flexible option for the RBI—the others have a cost attached and require higher operational involvement.
The RBI has said this is an interim measure applicable only to incremental deposits and hence, the expectation is that it will get addressed at a later date once normal money supply resumes in the banking system.
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