4 min read.Updated: 15 Dec 2021, 11:17 PM ISTMadan Sabnavis
A complex set of economic conditions would be needed for India to attain normalcy on this count
When the US Fed started its quantitative easing (QE) plan, it was to make liquidity available at a time when every institution was suspicious of the solvency of the other, as it was unclear how toxic their assets were. To help, the Fed bought other bonds apart from US treasuries.
India’s QE has been different. Large doses of liquidity have been provided by the Reserve Bank of India (RBI) starting in 2020 even before covid, when it used its LTRO (long term repo operations) and OMO (open market operations) as tools. This was later topped with TLTRO (targeted long-term repo operations) and its GSAP (government securities acquisition programme). In its pandemic response, RBI had stated that it would do everything needed to ensure adequate liquidity in the banking system. Banks could lend this money at low interest rates, which was the crux. RBI’s repo rate was lowered, as was the CRR (cash reserve ratio). The Centre backed this programme by providing a credit guarantee for loans given to micro, small and medium enterprises (MSMEs), a scheme that was subsequently expanded to include multiple sectors.
Let’s look at the consequences. Liquidity evidently increased: Almost ₹6-8 trillion of surplus liquidity resides in RBI’s reverse repo window (both overnight and short-term variable rate reverse repo or V3R). This surplus has just been increasing as RBI kept buying paper from banks to provide liquidity. But deployment avenues were limited for a variety of reasons.
First, demand was anaemic, with low capacity utilization rates in most sectors (60-69%) holding back investment. Second, private investment in infrastructure hasn’t yet taken off. Third, while MSMEs borrowed on the back of the guarantee, the funds were used to repay loans and maintain business rather than for growth. Fourth, banks too were cherry picking customers as they had just about come to get bad loans off their books. Besides, the backstop’s precondition on loan performance as of 1 March 2020 meant that stressed units did not qualify.
The puzzle was the success of RBI’s bond acquisition spree through GSAP, as it went about buying securities from banks. Together with OMO, a total of ₹2.4 trillion has been released by RBI so far this year with the goal of anchoring yield expectations. The logic of this was hard to understand because there was little point in banks giving up securities which paid an annual interest rate of, say 5-7%, depending on their residual tenor, to get cash that was put in the reverse repo or V3R window for returns of just 3.35-3.75%. These operations led to a negative carry for banks. It would have made sense if they procured liquidity to extend loans at 9% or more per annum. One justification was that the securities were illiquid and banks got a chance to offload these even though their returns were ultimately negative.
How RBI exits a surplus scenario of ₹8 trillion is now a challenge. Curbs on its reverse repo window would spook the system. Raising the reverse repo rate will be taken as a policy signal of tightening, which would not be in consonance with its current commentary. GSAP buys have stopped, which is fine, but it does not address the issue of surplus liquidity.
Banks, on their part, are trying their best to stop deposits from coming in by keeping interest rates low. This being so, it’s no surprise that funds are moving to equities and crypto assets. While this can ensure surpluses don’t increase, it does not reduce them either.
Ironically, financial markets have not quite reacted positively to surpluses, as government bond yields remain high in relative terms, with the 10-year yield in the region of 6.35%, up from under 6% till 21 January. In fact, there has been a battle between RBI and bond players, with the latter demanding higher yields (lower prices). There was a phase of RBI auctions not going through or devolving on primary dealers. Almost ₹1.5 trillion of auctions went unsubscribed by the market this year. Therefore, surplus liquidity has not really reduced interest rates sharply, though it could counter-intuitively be argued that rates would’ve gone up further, with the 10-year paper crossing 7%, had RBI not acted as it did.
The market has been wary of high government borrowing and inflation. The Centre’s borrowing programme is to be retained at around ₹12 trillion for the year, while inflation is expected to be around 5.5%. The recent supplementary demand put before Parliament involving ₹3 trillion of cash payouts does mean higher borrowing at some point of time. Besides, if GST revenues don’t remain buoyant, the government’s need for additional borrowing to plug shortfalls in GST-compensation-cess collections would increase.
It does look as if draining excess liquidity will require a combination of some developments. First, bank credit demand must pick up, with the economy’s investment cycle turning around. Second, the Centre should be borrowing more so that banks automatically channel their surpluses back. Third, RBI should be going in for some OMO sales to reverse its GSAP effort, so that these securities return to banks. Until these happen, either thanks to a central bank push or through the natural course of events, big surpluses will stay.
More importantly, the relationship between surplus liquidity and interest rates will remain severed.
Madan Sabnavis is an independent economist and author of ‘Hits & Misses: The Indian Banking Story’