India’s financial system is currently running a deficit of around 1.2 trillion and banks have been borrowing money from the Reserve Bank of India (RBI) to meet their daily cash requirement. RBI last week reopened a second window for liquidity adjustment facility (LAF) to ease the liquidity crunch. The additional liquidity support under LAF, which will be available till 16 December, is up to 1% of banks’ deposits.

Under RBI norms, banks are required to invest 25% of their deposits in government bonds. Such investment is known as SLR (statutory liquidity ratio) investment and if it falls below 25%, banks are penalized. RBI has allowed them to keep a 24% SLR till 16 December.

Also Read Tamal Bandyopadhyay’s earlier columns

This will help them borrow around 50,000 crore extra, roughly 1% of the Indian banking system’s deposit base. Banks require government bonds to offer as collateral to RBI to borrow cash from it. By paring the SLR holding requirement to 24% as an “ad hoc, temporary measure", RBI has enabled them to have excess SLR bonds that can be offered as collateral to borrow money.

Those that don’t have excess SLR bonds would need to borrow from the overnight call money market, and if the demand for overnight money is excessive, the call money rate will go up. Ideally, the interest rate in the overnight money market should be between 5.25% and 6.25%—the corridor between the Indian central bank’s two policy rates—but in the recent past, it shot up to 12% as banks did not have enough excess SLR bonds and rushed to borrow from the market.

In its mid-year policy review early this month, RBI committed to contain the liquidity deficit “within a reasonable limit" —around 50,000 crore, or 1% of the deposit liability of the banking system. Apart from infusing liquidity through its repo window, the central bank also plans to buy bonds from the market under the so-called open market operations (OMOs). The government has so far bought back bonds worth 2,148 crore. RBI, in its first OMO early this month, bought bonds maturing in five, six and even 10 years worth around 8,000 crore against a target of 12,000 crore, but has developed cold feet since then as such buybacks distort the yield curve in the bond market.

So, what can it do to ease the liquidity crunch? Before answering this question, let’s look at the causes of the liquidity crunch. The government has mopped up at least 1 trillion from companies as telecom licensing fees and another 15,000 crore by selling shares of Coal India Ltd. It has already raised 3.5 trillion from the market and its tax collection has also improved.

On account of these factors, money flowed out of the system, but has not come back as the government is not spending much. Its account kept with RBI is now running a surplus of 1.14 trillion. In other words, there is no systemic problem, but there is not enough money for the banks. This is technically called a “frictional liquidity" problem and is normally short-lived. But along with this, there is a structural liquidity issue, too. There is a spurt in money in circulation or the cash that is physically used to conduct transactions between consumers and businesses rather than stored in the banking system.

Currency in circulation, or currency in hand, as it is popularly known, is part of the overall money supply, but banks cannot use this money to give loans to the borrowers. Typically, when the inflation rate is high and bank deposits do not offer adequate interest rates to take care of inflation, people tend to keep money in their wallets and spend more. Between March and October 2010, currency in circulation was 70,814 crore—a little less than 1.5% of total bank deposits—against 46,083 crore in the comparable period last year.

The liquidity crunch will intensify with the government raising more money through sale of shares in public sector undertakings and corporations paying advance tax for the current quarter in mid-December.

One way of easing the liquidity crunch could be cutting the cash reserve ratio, or the portion of deposits that commercial banks need to keep with RBI. It is currently pegged at 6%. This won’t happen as it goes against the grain of a tight monetary policy, which is aimed at fighting inflation.

A second route could be RBI’s intervention in the foreign exchange market. For every dollar RBI buys from the market, an equivalent amount in rupees flows into the system. But the banking regulator has, by and large, been staying away from the market and its stated position is that intervention is necessary only to curb excess volatility in the market and not to check any appreciation of the local currency. Besides, a stronger rupee also helps RBI to fight inflation as the cost of imports declines.

So, we are left with the option of OMOs—the government or RBI buying back bonds from the market to infuse liquidity. While a buyback by the government releases money from its account, an RBI buyback of long-dated securities could be interpreted as new money creation.

The best solution could be buying back short-term treasury bills from the market as a buyback of long-term dated securities can distort the yield curve. Right now, the market has outstanding treasury bills of around 2 trillion and around 40% of this is state government paper. The treasury bills of the Centre could be bought back.

At the same time, the government can also go slow in raising money from the market through fresh treasury bills as well as dated paper. It has pared its 4.5 trillion gross annual borrowing programme by 10,000 crore, but that’s too small an amount to destress the system.

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