RBI has been managing liquidity quite well in challenging times

RBI has brought a lot of dynamism to the money market with an array of tools being used to manage liquidity and bond yields in a non-disruptive manner.
RBI has brought a lot of dynamism to the money market with an array of tools being used to manage liquidity and bond yields in a non-disruptive manner.

Summary

  • India’s central bank has managed its liquidity adjustment facility (LAF) corridor quite well under trying conditions. It’s fair to say that the money market in India is better evolved now.

The country’s money market is very sophisticated today, with the Reserve Bank of India’s (RBI) liquidity framework now targeting the call money rate. The call-money market is the ultimate refuge for banks to manage their surpluses and deficits after exhausting all other options. With its liquidity adjustment facility (LAF), RBI targets the weighted average call money rate to keep it in a range of 6.25% to 6.75%.

Gauging liquidity in the banking system has become complex because of several factors at play. Normally, one looks at the net liquidity position of banks, as provided by RBI on a daily basis. This can be in deficit or surplus, and if any trend persists for a certain period of time, it is possible to characterize the system accordingly. 

The net position is a result of both the flows and stocks of money provided and absorbed by RBI. The liquidity framework being pursued deploys VRR (variable rate repo) and VRRR (variable rate reverse repo) auctions to balance liquidity. In the first case, RBI provides liquidity to the system, while in the latter, it absorbs the same. Both of these operate on a relatively longer-term basis, which is more than a day and can start from three days and go up to 14 days, if not more.

The RBI framework’s rate corridor ranges from 6.25% to 6.75%. Typically, the VRR rate is in a range of 6.51-6.74%, which is the upper corridor, with the central bank’s MSF (marginal standing facility) rate fixed at 6.75%. The VRRR rate ranges from 6.26% to 6.50%, as the corridor’s floor is set by RBI’s SDF (standing deposit facility) rate of 6.25%.

There have been anomalies here. We have seen net deficit levels of 1-1.5 trillion on a daily basis, as has been the case since April. Yet, the bank surpluses that have flowed into the SDF have been buoyant and could lie in a range of 60,000-80,000 crore. This shows that the system is not one-sided. Some banks have surpluses and invest in RBI’s overnight SDF for a return of 6.25%, while those with cash shortfalls borrow at 6.51-6.75% through the VRR and MSF windows. A closer picture is difficult to get.

Also read: RBI to review framework on Liquidity Coverage Ratio

When individual banks raise their deposit rates for certain maturities, observers often wonder if others will follow. A clue is that banks manage their balance sheets to match the maturities of their assets and liabilities to the extent possible. Hence, if there is a mismatch, there’s a tendency to increase rates on deposits of certain tenures to match those of assets (loans given out, i.e). Such micro moves may be purely for internal reasons.

Three elements are at work all the time. The first is what’s predictable, like tax payments to be paid on a quarterly basis. Similarly, when salaries are paid at the end of the month, liquidity improves as deposits increase. Then second factor is less predictable, which is the level of government cash balances that reside with RBI (and are not in the system). 

When the government spends, funds re-enter the system, as recipients get money that is deposited. This increases liquidity. The third is probably the least predictable, which is deposit and credit growth. If households prefer mutual funds, then deposits come down. If companies borrow more, credit growth picks up and affects the liquidity situation. These trends evolve over time and must be watched on a fortnightly basis.

Also read: Liquidity coverage: Don’t add to the regulatory burden on banks

Government cash balances deserve comment. As the government works towards ensuring that its fiscal deficit is contained, a tendency arises to hoard revenue earned. These balances tend to come down towards the end of every quarter as spending picks up, with the highest expenditure usually recorded in March. 

This holds for both the Centre and states, and these cycles influence the system’s overall liquidity situation. Improved adherence by the government to the country’s Fiscal Responsibility and Budget Management (FRBM) guidelines would make the impact of this component easier to forecast and plan for.

Under these circumstances, RBI has maintained the liquidity situation in the market quite adroitly through its framework. Of late, however, a new twist has been added with the announcement of buybacks of government securities. This happens at a time when government cash balances are somewhat high and liquidity is under some stress. 

Also read: RBI decides to allow reversal of liquidity facilities under both SDF, MSF during weekends and holidays, says Das

In the past, the option exercised was for the central bank to go in for open market operations (OMO) where securities were purchased by RBI from banks so that liquidity improved. Unlike repo operations, which are temporary in nature, OMO is a permanent measure of infusing or withdrawing funds. 

The buyback formula being adopted today can be interpreted as the government withdrawing its debt by using cash balances. This way, RBI holdings of government paper do not increase. An alternative could have been to just hold back on weekly auctions. But the messaging would be different that way. A bond buyback conveys immediacy and sends a strong signal to the market.

On the whole, RBI has brought a lot of dynamism to the money market with an array of tools being used to manage liquidity and bond yields in a non-disruptive manner. The buybacks have not been fully subscribed, though, given the pricing; banks may be waiting to sell their assets at higher prices to book profits. 

But if bond prices rise, as they did on news of RBI’s bumper surplus, it would mean yields fall, which would send a signal to the market that they might be softening. This would go against RBI’s message to banks that the transmission of its repo rate hikes is not yet complete.

These are the author’s personal views.

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