Modi’s demonetisation move risks bond shortage for RBI

Banks had a record Rs4.3 trillion parked with the RBI against bonds as of 22 November, fast-approaching all of the Rs7 trillion worth of notes the RBI has on its books to offer


The RBI will have to resort to short-term tools like cash bills if it wants to keep money markets stable. Photo: Aniruddha Chowdhury/Mint
The RBI will have to resort to short-term tools like cash bills if it wants to keep money markets stable. Photo: Aniruddha Chowdhury/Mint

Mumbai: Prime Minister Narendra Modi’s shock ban on high-denomination currency notes may present a tricky situation for India’s central bank: a shortage of bonds needed to manage its money-market operations.

As citizens in Asia’s third-largest economy rushed to submit now defunct Rs500 and Rs1,000 bills, about Rs6 trillion have been deposited at lenders since Modi’s 8 November move. Banks had a record Rs4.3 trillion parked with the Reserve Bank of India against bonds as of 22 November, according to India Ratings & Research Pvt. Ltd. That’s fast-approaching all of the Rs7 trillion worth of notes the RBI has on its books to offer as collateral to banks parking excess funds with it.

The situation calls for action from authorities as a banking system awash with unused cash could cause borrowing costs to crash, threatening to hurt financial stability in the $2 trillion economy. While the RBI risks running short of bonds to offer to banks, the European Central Bank was earlier this year faced with a dearth of securities to purchase under governor Mario Draghi’s bond-buying program.

“The pace of increase in banking system liquidity suggests that the RBI may have to soon resort to liquidity mopping up tools that are beyond its current tool chest,” said Vivek Rajpal, an interest-rates strategist at Nomura Holdings Inc. in Singapore. “We can reach a situation wherein the RBI resorts to tools like issuing cash-management bills or a standing deposit facility where it sterilizes without need of collateral.”

Modi’s move sucked out 86% of India’s currency in circulation, giving people until 30 December to exchange the defunct notes for fresh ones. The decision, aimed at weeding out unaccounted wealth and curbing tax evasion, rattled the world’s second-most populous nation, where about 98% of all consumer payments use cash.

Have tools

“We have a number of tools to deal with these issues,” a spokeswoman for the RBI wrote in an e-mailed response to questions.

The monetary authority already seems to have started draining out excess funds by increasing amounts and tenures of reverse-repurchase agreements under its liquidity-management operations. The Rs4.3 trillion parked with the RBI far outstrips the previous record of Rs1.7 trillion seen in May 2009, according to India Ratings, a unit of Fitch Ratings.

The biggest currency swap in India’s history has been complicated by the temporary caps that the government has put on the amount of cash people can withdraw from banks while it prints new notes to replenish the funds. That’s making it hard to estimate how much of the deposits will remain in the system after 30 December.

Temporary measure

“It is an unprecedented and irregular situation,” said Soumyajit Niyogi, a Mumbai-based associate director at India Ratings. The RBI will have to resort to short-term tools like cash bills if it wants to keep money markets stable.

The government’s decision is expected to disrupt economic activity and damp consumption in the short term. Credit Suisse Group AG and Deutsche Bank AG have already slashed their economic growth forecasts for India. Goldman Sachs Group Inc. said in a 22 November report that the central bank may opt to sell bonds via its open-market operations to reverse some of the liquidity it has injected over the past year, if it feels the excess system liquidity is “durable” in nature.

Another “temporary measure” could be to raise the cash reserve ratio, said Indranil Pan, chief economist at IDFC Bank Ltd in Mumbai. The CRR can be cut again once liquidity in the banking system stabilizes in the first few months of 2017, he said.

Banks in India need to set aside a minimum of 4% of their deposits as cash with the RBI, called the cash reserve ratio, without earning any interest on them. Bloomberg

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