Mumbai: The unexpectedly large inflows under the Reserve Bank of India’s dollar mobilization scheme have created a new liquidity headache for the central bank, one that could linger for a while. The scheme announced early June was aimed at drawing foreign currency inflows and bolstering the rupee amid pressure on the currency.
Three months on, while the pressure is not off the rupee, the banking system is awash with liquidity, with the surplus likely to remain elevated through the fiscal year and perhaps longer, potentially forcing the RBI to weigh fresh measures to absorb the excess without disrupting the bond markets or hurting bank profitability, three treasury officials and four economists said.
RBI’s dollar mobilization scheme drew $136.4 billion by 31 August, far exceeding initial expectations, with foreign currency non-resident (bank) or FCNR(B), deposits accounting for $127.2 billion, or more than 90% of the total, while offshore foreign currency bonds (OFCBs) and external commercial borrowings (ECBs) contributed $5.3 billion and $3.9 billion, respectively, per central bank data. The inflows have also helped push India’s foreign exchange reserves to a record $740.8 billion as on 28 August, strengthening RBI’s buffer to manage volatility in the rupee.
The scale of inflows has translated into a sharp increase in rupee liquidity. Systemic liquidity, which was in a surplus of about ₹2.05 trillion when the scheme was announced on 5 June, rose to ₹6.70 trillion end August and to ₹10.54 trillion on 3 September, per Bloomberg. A day before the announcement, the surplus was ₹1.88 trillion.
To be sure, too much liquidity for too long can keep short-term interest rates lower than what the RBI would like, blunting its monetary policy signals. It can also encourage more lending and spending, potentially fuelling inflation and creating risks in financial markets.
Treasury officials expect the surplus to remain sizable even after the usual seasonal drains from advance-tax payments, currency leakage and other balance-of-payments flows.
“This amount is something which banks will have to find avenues to lend to and domestic deposits would continue to grow even as the FCNR(B)-linked liquidity enters the system," said Madan Sabnavis, chief economist at Bank of Baroda. "So, I think there will definitely be surplus liquidity in the system for a longer duration.”
He expects the system could still be left with around ₹10 trillion of surplus liquidity after these drains, and said that the excess could remain above ₹5 trillion through FY27.
RBI has already been actively absorbing excess liquidity through variable-rate reverse repo (VRRR) auctions, announcing operations totalling ₹53.5 trillion between 6 August and 2 September, according to a report by Bank of Baroda on 3 September. But given the size and persistence of the surplus, market participants believe the central bank may need to use a combination of instruments, rather than rely solely on short-term liquidity sweeps.
One option is an incremental cash reserve ratio (CRR), under which banks would be required to park a larger share of their incremental deposits with the RBI.
But such a measure is likely to attract limited support. Gaura Sengupta, chief economist at IDFC First Bank, said a CRR hike could penalize banks that did not raise FCNR(B) deposits, while those that brought in the foreign currency deposits had already benefited from their exclusion from CRR requirements.
“I don’t think they should use CRR hike, because all the FCNR(B) deposits are exempt. You are penalizing banks who didn’t get deposits,” a senior treasury official at a private sector bank said.
While this will have an immediate impact, such a move could be viewed as effectively unwinding RBI's earlier decision to exclude these deposits from CRR and SLR (statutory liquidity ratio) requirements, Radhika Rao, senior economist and executive director at DBS Bank, said in a note on 3 September.
“Plus, the asymmetrical availability of FCNR related liquidity might put smaller/mid-sized institutions at a disadvantage. To get around this, the ratio might be in proportion to increase banks’ net demand and time liabilities (NDTL) to ensure it syncs with the scale of funds raised amongst banks,” she said.
The market stabilisation scheme (MSS), under which the government issues securities to absorb liquidity, is another option.
Sengupta sees a problem here as well because the government would have to bear the interest cost, while Sabnavis believes MSS could substitute part of the government’s conventional market borrowing.
The third option is open-market-operations (OMOs), when the RBI can sell government securities to absorb rupees from the banking system. Sabnavis believes an OMO could be preferable for banks because the securities would generate a market return, rather than the lower return available from parking funds in VRRR operations.
Rao also listed OMOs and MSS among the options before RBI, while warning that both could push up bond yields. Treasury officials believe large OMO sales could put additional pressure on an already challenging government bond market. On Friday, yield on the 10-year benchmark gilt ended at 6.96%, up from 6.83% a month ago.
There is yet another possible tool that could be explored: sell-buy foreign exchange swaps. But the view on their usefulness is disputed. Under such swaps, banks sell dollars to RBI in the spot market and simultaneously agree to buy them back at a future date, allowing the central bank to absorb rupee liquidity for the duration, while banks retain access to the foreign currency later.
Sengupta said a short-term sell-buy swap could help absorb liquidity, but it should be of short-term maturities and the scale limited. Sabnavis, however, questioned the purpose of the instrument if banks simply need to retain the dollars they receive.