Focus on surplus liquidity with rate cut seen remote

With the Reserve Bank of India (RBI) expected to maintain status quo on benchmark rates in the monetary policy review on Friday, expert opinion is divided on whether the time is ripe for the central bank to absorb surplus liquidity.

According to estimates, there is currently ₹5.31 trillion excess liquidity in the banking system following a series of steps by the central bank to boost liquidity to revive a contracting economy impacted by the pandemic.

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Harihar Krishnamoorthy, treasurer at FirstRand, said RBI should continue with its accommodative policy stance to sustain the fragile economic recovery with the latest set of GDP numbers registering a better-than-expected rebound.

“The current liquidity surplus has pushed retail savers to invest in cars and real estate. We will need many more months to ensure sustained recovery. The possibility of a rate cut is low at this point, and RBI hopefully should not announce any measures that will suck out the excess liquidity, which is helping the consumption revival,” he said.

However, some believe the central bank should announce measures to address excess liquidity that is likely causing the equity markets to overheat and stoke retail inflation, which touched 7.27% in November, way above RBI’s upper margin of 6%.

“With so much liquidity floating around, and bank credit still on the slow growth trajectory, as a matter of policy, RBI should be directing liquidity flow towards the long-end given the excessive fall in short-end yields. One way of achieving this is by advancing the CRR (cash reserve ratio) cut, which is expiring on 27 March, which would lead to the draining of ₹1.46 trillion from the market. To balance that, RBI should announce a simultaneous open market operation of an equivalent amount,” said Soumyakanti Ghosh, chief economist, State Bank of India.

Some experts also believe that instead of squeezing out the liquidity, RBI could tread the middle path by fixing the floor price on overnight rates that have fallen to record lows. “The simplest solution is for RBI to introduce variable rate reverse repos (VRR) for a fixed quantum of say ₹4 trillion. By encouraging banks to bid closer to repo rate in this VRR, RBI can push up the weighted average remuneration to banks in the LAF (liquidity adjustment facility) window. This would then pull up rates in the call and tri-party repo markets,” said ICICI Securities in a recent note.

Another option for RBI could be to introduce a standing deposit facility (SDF) to absorb deposits from commercial banks without giving government securities in return that has been handy in sucking out large amounts of excess liquidity in extraordinary situations.

“RBI has been intervening in the forex market to manage volatility in the exchange rate and also in the bond market to create demand for government auctions. However, due to huge capital flows and negative growth rates, the intervention by RBI in both currency and rates market is resulting in a liquidity flood, as RBI is buying foreign currency and bonds in parallel to meet the aforesaid objectives of checking volatility in exchange rates and support growth by keeping interest rates low,” said Ashutosh Khajuria, executive director and chief financial officer, Federal Bank. This combination of forex purchases and domestic purchases resulted in core or durable liquidity surplus exceeding ₹9 trillion.

RBI has accumulated $93 billion in forex reserves (over ₹6 trillion) in this fiscal so far, the highest on record since the fiscal year 2008.