Later this week, the Reserve Bank of India (RBI) will release its six-weekly review of monetary policy. Not too many bankers are discussing this because RBI governor D. Subbarao has hinted that the central bank would not tinker with policy rates in its December review.

Also Read |Tamal Bandyopadhyay’s earlier columns

All eyes are on the tight liquidity situation. The Indian financial system has been running a deficit of at least Rs1 trillion daily for the past few weeks and banks are borrowing money from RBI to take care of short-term asset-liability mismatches. The liquidity crunch will intensify this week with a Rs45,000-50,000 crore outflow of advance tax. Indian companies pay tax every quarter on projected profits. The payment of such tax for the December quarter is due this week.

RBI is currently keeping two windows open for the so-called liquidity adjustment facility (LAF) to ease the liquidity crunch. It has also allowed additional liquidity support under LAF—up to 2% of banks’ deposits.

Banks are required to invest at least 25% of their deposits in government bonds and if such investment—known as statutory liquidity ratio (SLR)—falls below 25%, RBI penalizes them. But RBI has allowed banks to keep a 23% SLR till 28 January. This will enable banks to borrow around Rs1 trillion extra, about 2% the deposit base of the industry.

When banks borrow money from RBI, they need to offer government bonds as collateral. Once their SLR requirement is brought down to 23%, they will have excess SLR bonds to offer as collateral to borrow extra money.

There are various reasons for the liquidity crunch. One obvious factor is lower deposit growth. In the fiscal year so far, banks’ deposit portfolio has grown by Rs2.96 trillion, or 6.6%, against credit growth of Rs3.22 trillion, or 9.9%. Similarly, between December 2009 and November, deposit growth has been Rs5.88 trillion, or 14%, against credit growth of Rs6.58 trillion, or 22.6%.

If the resources in the banks’ kitty cannot keep pace with the growth in credit, there is bound to be scarcity of money. But there is another critical factor. The government is mopping up a bulk of the money from the system in various ways. Traditionally, the government borrows money from the financial system to bridge its fiscal deficit. This year, its plan is to borrow Rs3.45 trillion net of redemptions of old bonds, and Rs2.89 trillion has already been raised.

In addition to this, it has also taken Rs1.06 trillion in the form of licence fees from telecom firms. In banks’ books, this is shown as credit to corporations (which raised money from banks to pay for their licence fees) but, ultimately, this money went to government coffers. Finally, the government has also raised Rs24,000 crore from the capital market through its disinvestment programme, out of its annual target of Rs40,000 crore. Money raised through disinvestment may have helped the government bring down its fiscal deficit a tad but, ultimately, this money is also sucked out of the system; instead of issuing bonds, the government, in this case, is selling shares.

Through sale of bonds, shares and telecom licences, the government has raised Rs4.17 trillion this year, higher than the deposit growth. This is possible because banks are not the only subscribers to government bonds (there are insurance firms and others) and the entire divestment proceeds have not come from the banking system (there are other firms such as foreign institutional investors). But the fact remains that the government is the biggest money raiser from the system and the money is not coming back as it is not spending it. The government keeps its money with RBI—its cash balance with the central bank is at least Rs91,000 crore.

Even if the government spends its entire cash balance with RBI, the cash deficit in the system cannot be taken care of on a sustained basis, but it will ease the crunch to a great extent. If it does not wish to do so, it can consider keeping its money with commercial banks.

The Chinese central bank does so. According to Reuters reports, in August it auctioned 40 billion yuan ($5.9 billion) of three-month deposits with commercial banks at 4.1%. On 16 December, China’s central bank will auction 40 billion yuan ($4.5 billion) of six-month deposits, a part of its finance ministry’s cash management programme. Similarly, Agence France Tresor, the debt management agency of Banque de France, invests surplus cash in the interbank market in the form of unsecured loans. In the absence of government spending, RBI has been buying bonds from the market to infuse liquidity under its so-called open market operations. So far it has bought back bonds worth Rs18,400 crore and also cut the size of at least one government bond auction by Rs5,000 crore.

Other options of liquidity infusion before the government are cutting the cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with RBI, and intervention in the foreign exchange market. But, both are unlikely. RBI is following a tight monetary policy to fight inflation and is willing to intervene in the foreign exchange market only to curb excess volatility, and not to check any appreciation of the local currency. Besides, a stronger rupee also helps RBI fight imported inflation, especially at a time when oil prices are on the rise.

There are very few choices before the Indian central bank. Since a buyback of long-term bonds can distort the yield curve in the government bond market, RBI can focus on repurchase of short-term treasury bills. It can also raise the rates of deposit for non-resident Indians to attract short-term money.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai.

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