Some observers have described the Reserve Bank of India’s (RBI) revised liquidity management framework as quantitative easing (QE), Indian-style QE, QE-like or cautious QE. Unfortunately, all these descriptions are incorrect. So, what exactly has RBI announced, what are its implications, and why and where is the misunderstanding?

To be fair, the intricacies of liquidity management and central bank balance sheet aren’t topics as suited to casual everyday opinions as, say, the goods and services tax (GST) or labour market reforms. Most market participants appear to have been disappointed by the absence of a bigger 50 basis point cut in the repo policy rate, at which banks undertake collateralized borrowing from RBI. However, the guidance about the revamped liquidity management regime has been well received. This is because either the proverbial plumbing of liquidity management is well understood or, in some cases, the link between a central bank’s liquidity operations and its balance sheet isn’t well appreciated (i.e. the QE camp).

Specifically, RBI has announced that it would progressively lower the average ex ante liquidity deficit in the system from 1% of net demand and time liabilities (NDTL) to a position closer to neutrality. The move is significant because until last week’s announcement, RBI had not bought into the complaints by banks that liquidity is too tight. Indeed, it reasoned that its liquidity management had ensured the weighted average call rate (WACR), the operating target for monetary policy, was close to the policy repo rate.

This was a unique situation where both sides were right but for different reasons. The common link in this jigsaw puzzle is the nature of liquidity—temporary versus permanent—being injected by RBI. Its overall liquidity injection ensured that the WACR tracked the policy repo rate. However, there was increased reliance on injecting temporary liquidity when a more permanent (or durable) injection was warranted.

Inadequate and durable liquidity injection caused banks to fret and cite it as a factor affecting their ability to cut deposit. This in turn compromised effective transmission of the prior policy rate cuts. Indeed, in its policy statement, RBI acknowledged: “…the provision of short-term liquidity does not substitute fully for needed durable liquidity, though durable liquidity can substitute for short-term liquidity needs".

The revamping of the liquidity framework is an important evolutionary step that is in sync with the Urijit Patel panel report. Essentially, RBI is more confident of its daily market-driven management in the liquidity adjustment facility (LAF), which is used to aid banks with their short-term liquidity mismatches. Until a few years ago, this was done by banks borrowing at the central bank’s fixed overnight repo window, if they were short, or by parking surplus liquidity at the lower fixed reverse repo window.

In order to encourage the use of term repos, RBI governor Raghuram Rajan had capped liquidity injection at the overnight repo rate window while offering the balance via term repo auctions. The aim was that over time, banks would have to stop relying on RBI for liquidity support solely at the fixed rate window and instead adapt to floating rates at each auction.

The availability now of variable rate reverse repo auctions also eliminates a pesky aspect of the earlier framework—excess liquidity pushing the overnight rate away from the repo policy rate to the reverse repo rate, the lower end of the LAF corridor. In the absence of this new instrument, the choice for the RBI was to either keep the system short of liquidity to ensure the sanctity of the repo rate as the single policy rate, or flip between repo rate (when policy is being tightened) and reverse repo rate (policy is being eased). Most economies don’t have this strange complication of different policy rates depending on easing or tightening.

Finally, why is RBI’s approach of moving the system liquidity to near neutral from deficit not QE? Part of the confusion is because the liquidity deficit is thought of as being cured by additional money printing. The reality is that the overall liquidity support by RBI isn’t changing, though it will be more durable. There is no excessive money creation, which is the hallmark of QE. RBI will inject durable liquidity (i.e. reserve money) as needed and then adjust the short-term liquidity to be consistent with its stance. Frankly, I must confess to being intrigued about why RBI wasn’t already doing this.

The reduction in government cash surplus and the return of the recent excessive currency leakages into the banking system will affect the frictional liquidity deficit. To move to around neutral, RBI has to shrink the liquidity deficit by 80,000-90,000 crore, significantly less than the reported deficit at the end of March. The pace will be subject to RBI buying foreign exchange assets depending on its intervention in the currency market and capital inflows. However, the adjustment will be gradual over the next one-two years.

The new framework modernizes liquidity management by making it more market-based. It will also improve monetary transmission without excessive money creation. Banks, however, will have to buckle up to improve their own liquidity management.

Rajeev Malik is a senior economist at CLSA, Singapore. These are his personal views.

Comments are welcome at thierview@livemint.com

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