There has been a neat arbitrage possibility for banks over the past week. They can technically borrow overnight money at a fraction of a per cent, then lend it to the Reserve Bank of India (RBI) at 6%—and pocket the difference. Ideally, such arbitrage should have pushed up interest rates on overnight money to 6%, as banks parked their excess funds with the central bank rather than lend to one another.
That’s the theory. In practice, interest rates continue to be below 1% because RBI has said it will not borrow more than Rs3,000 crore a day from banks. The arbitrage opportunity has been capped. So, there continues to be a flood of excess liquidity in the market, though RBI is likely to move soon to mop up as much of it as possible. This flood comes just two months after a drought, when overnight interest rates went up as high as 60%. This crazy volatility should be a matter of worry.
RBI manages day-to-day liquidity through its liquidity adjustment facility (LAF), which allows it to suck out excess liquidity or inject it when there is a shortage. The goal is to keep short-term interest rates between the repo and reverse repo rates—or between 6% and 7.75% right now. Yet, this corridor has often been breached in recent months.
The confusion at the short-end of the money market has serious implications for the conduct of monetary policy. With financial deregulation and closer integration of various financial markets, central banks the world over have realized that tinkering with interest rates is a more effective policy tool than changing bank reserves. In the Indian context, this means that changes in the statutory liquidity ratio (SLR) and cash reserve ratio (CRR) are less effective than before. Interest rates are now clearly the most important channel for the transmission of monetary policy to the real economy.
It is short-term interest rates that are most responsive to signals from RBI. Rates at the other end of the yield curve tend to be more “sticky”. In other words, huge swings in short-term interest rates, as we have seen in recent months, could end up limiting the efficacy of RBI’s attempts to control inflation. There is far more at stake when interest rates drop to Japanese levels than is generally recognized.
One major reason why short-term interest rates have fluctuated so much is the cash surpluses that the government keeps with RBI. They wax and wane as the government collects taxes and spends its revenues. The rise and fall of government cash indirectly affects market liquidity and short-term interest rates. It is high time there is a plan to smoothen out these wild swings in government cash.
RBI’s new Report on Currency and Finance mentions some alternatives that will allow the government’s cash to move into the market in times of low liquidity. In Canada, for instance, this cash is auctioned though competitive bidding every day. The US government cash is invested directly in the market. There are many other models to try out. The point is that there now needs to be a long-term plan from RBI to manage government cash balances.
The recent collapse in short-term interest rates, however, has little to do with trends in government cash. Bankers say that it is because of the fact that RBI has tried to buy dollars after a long time to prevent the rupee from appreciating. By buying dollars, the central bank has released rupees in the market, thus pushing down interest rates.
Both banks and RBI need better methods to forecast and manage liquidity. The recent wild swings in short-term interest rates do not reflect too well on either of them.
Effective monetary policy requires the maintenance of more orderly conditions in the money market.
Are the wild swings in short-term rates a cause of major worry? Write to us at email@example.com