India’s topsy-turvy money market needs a remedial plan | Mint

India’s topsy-turvy money market needs a remedial plan

Addressing issues in India’s money market has become especially complex because banks tend to have varying levels of surpluses and deficits. (Photo: Mint)
Addressing issues in India’s money market has become especially complex because banks tend to have varying levels of surpluses and deficits. (Photo: Mint)

Summary

  • Varying liquidity at banks in recent months has played a big role in anomalies that could possibly be fixed by a shift in RBI’s approach.

The money market in India has witnessed unusual scenes in the last few months. There has been pressure on liquidity ever since the Reserve Bank of India (RBI) introduced an incremental cash reserve ratio (ICRR). About 1.1 trillion withdrawn through it turned the market around. From a state of surplus liquidity, the system now tends to be in a state of deficit on several days, exhibiting some curious tendencies.

To begin with, there has been a deficit caused by variance in the growth of bank deposits and credit. The latter has outpaced the former. As of 3 November, incremental deposits were 15.36 trillion (excluding the HDFC Bank merger), while growth in credit was 13.06 trillion and in investments, 5.9 trillion. Hence, a direct deficit of around 3.6 trillion is visible.

However, the quirky part of the market is that the liquidity status of banks differs. There are some with surplus liquidity, while others are in perennial deficit. This is evidenced by frequent use of RBI’s marginal standing facility (MSF) window, through which money is provided on an overnight basis at a fixed rate of 6.75%. It reflects the liquidity strain. On the other hand, there are surpluses with some larger banks that are parked in the standing deposit facility (SDF) at a 6.25% return.

Then there are periodic variable rate reverse repo (V3R) auctions held by RBI in which the scheduled amount normally is 50,000 crore for, say, 14 days, but only a fraction of it is subscribed by banks. Banks are not too forthcoming with their investments at this window. The reason is that they do not want to lock-in their funds for a long tenure and prefer to use the SDF window, even though the return there is 6.25%, as against V3R’s 6.49%. Disparate levels of liquidity give cash-surplus banks a chance to earn a better return in the call market.

But this anomalous market situation of differentiated liquidity also means that there will always be banks that need funds on a daily basis. RBI’s MSF funds come at 6.75% and there are limits to which this window can be accessed. It is the call money market that first gets into action, where banks with surplus funds lend to those who need them. So long as the rate is up to 6.74%, or just under the MSF rate, banks in deficit will borrow from the call market before accessing the MSF facility. And then, after using up their MSF limits, they may need to return to the call market. Hence, at times of high money demand, the weighted average call rate can go beyond the MSF’s 6.75%.

There are three things to be looked at here. The first is the constant fear of banks with surplus liquidity of running into a deficit, as credit conditions are uncertain. Therefore, some banks are simply unwilling to lock funds in the 14-day V3R window. Hence, they invest in these auctions only partly, and prefer to either get a daily 6.25% return from the SDF or a higher-than-repo rate in the call market.

The second issue is whether the return on the V3R window should be higher, if this is the clinching factor. This is important because RBI can have a cut-off that is closer to the MSF rate rather than the repo rate, to make this window attractive for banks. A higher return can channel surpluses to the V3R window.

The problem with this option is that the rate corridor, which should be between the SDF and MSF, will lose some efficacy at the upper end once V3R auctions get priced at 6.74%, say, instead of 6.49%.

To address this issue, a third factor could be looked at, which is the duration of the V3R window. Presently, variable reverse repo rate auctions are for 14 days. Shortening their tenure and setting a rate that is between the repo and MSF could work well. In fact, by doing so, a short-term yield curve could evolve for the market.

Addressing issues in India’s money market has become especially complex because banks tend to have varying levels of surpluses and deficits. Targeting the weighted average call rate makes sense, but the rate gravitates to the MSF in such situations. To counter this, a way could be to have daily repo auctions at 6.5%. Restoring the daily repo can be done in these unusual situations. This way, the call rate will come down and banks with surpluses would deploy them in V3R auctions, rather than the call market, as the V3R return would be higher. This can be part of RBI’s flexible monetary policy targeting.

In fact, RBI can also decide on whether there should be a limit on the funds that can be accessed through that window, which was done in the past. A level of 1 or 2% of net demand and time liabilities (NDTL) can be considered for individual banks. Alternatively, there can be daily variable repo rate (V2R) auctions priced between the repo and MSF rates to ensure greater control on the call market.

We need a different approach to address today’s anomalous situation. A lot of what has been suggested has been done in the past and is not really novel. The V2R has also been reiterated by RBI in its last few policies, but not really been implemented. This has pushed up the call money rate. The problem with a high call rate is that it also influences short-term bond yields, which tend to be elevated, reflecting the deficit in liquidity. Given that the 10-year yield has moved down, ideally short-term yields should follow suit. But they remain elevated due to the weighted average call rate. The corridor is narrowing when it should be widening.

These are the author’s personal views.

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