The Reserve Bank of India (RBI) is scheduled to announce its first bi-monthly monetary policy for 2016-17 on 5 April. While stock markets are hoping for a 50 basis points (bps) rate cut, bond markets expect easier liquidity.
The key reason why liquidity is a talking point is that since January, the liquidity deficit with banks has been as high as Rs 1.5 lakh crore to Rs 1.8 lakh crore versus the RBI's stated policy that the deficit should be around Rs 80,000 crore. Post advance tax payments on March 15, this deficit has gone up to Rs 2.5 lakh crore.
While the RBI says it is sorting out the deficit liquidity issue through fixed rate repurchase agreements (repos) and numerous variable repos, bank treasurers say banks will chase deposits to get cash.
In order to restore liquidity in banks, three issues will have to be addressed, namely, 1) how should the RBI go about reducing the cash deficit 2) How much should the deficit be and finally 3) should the RBI keep the banks in deficit when it is cutting rates?
Below is the verbatim transcript of Hitendra Dave and Neeraj Gambhir's interview with Latha Venkatesh on CNBC-TV18.
Q: Do you think the RBI has got its liquidity management all wrong?
Dave: There are two parts to it. One is the generic thought around what is an appropriate liquidity condition, whether it is a surplus, whether it is a deficit in the context of a given monetary policy situation, whether you are tightening, whether you are being accommodative etc. So, I think, that is one part of the debate and I am very pleased to note that the RBI after the last policy mentioned that they are undertaking a review of what is an appropriate level of liquidity because that has been a matter of significant debate in the market place about whether we should be 125 bps lower on the policy rate side but in terms of liquidity, we are more or less unchanged and as this discussion will show possibly we are a bit tighter.
The other part around the numbers that you mentioned from March of last year to March of this year, the loss of permanent liquidity on account of increase in the currency in circulation is roughly of the proportion of Rs 200,000 crore and there is another about Rs 40,000 crore higher, which the banks are maintaining by way of higher balances with the RBI. So that is permanent liquidity loss of about Rs 225,000-250,000 crore.
Against this, it is a simple set of how much has been added by way of permanent injections. We do know that RBI has only three tools of permanent injection, one is cash reserve ratio (CRR) which they currently don’t have a preference to experiment with.
Second is increase in their foreign exchange (Fx) assets.
Third is increase in their rupee assets and at least the numbers that we can figure out would suggest that they have added about Rs 56,000 crore by way of increase in rupee assets, which is the open market operations (OMOs) and the similar number by way of increasing the assets which is about USD 9-10 billion of purchases. So that leaves the gap of between Rs 70,000 crore and Rs 100,000 crore and the liquidity adjustment facility (LAF) number has gone that much higher.
Q: Would you broadly agree with these numbers that RBI's addition of liquidity has been less than the loss of liquidity because of Fx and other reasons?
Gambhir: The keyword here is permanent liquidity. This is a tautological statement that if the banking system is short of the central bank's primary liquidity then RBI has to provide that liquidity otherwise the banking system will be defaulting on its CRR requirements, which RBI does by way of its term repo operations because these operations are temporary, the system has to go back again to RBI for borrowing this money, which creates the sense of a lack of liquidity in the system. So, I think the keyword here is how much permanent liquidity that you are creating in the system or if not permanent, at least more enduring liquidity you are creating in the system and how fast are you creating that liquidity.
These calculations can be done at the beginning of the year with a reasonable degree of accuracy, what is the amount of permanent liquidity creation that the system will require but the question is whether you do it linearly through the year or you wait until a very late time in the year and then you create that liquidity. That is the key issue here in my mind.
Q: Normally, forex flows are healthy in January-March but this year probably because of the Chinese yuan devaluation and the scare about emerging markets, there was an outflow of capital. The RBI could not have done the OMOs earlier and if it did do the OMOs now, it runs the risk of further rise in M3 and therefore endangering its inflation position. Is that a fair argument?
Gambhir: I would say that any liquidity management of this nature requires -- given the institutional set-up that we have in India -- a considerable amount of judgement on behalf of the RBI to see when that permanent liquidity injection is required. What is the most appropriate time for it and if there are any changes in the real world as against that judgement then obviously it leads to either tightness of the liquidity or excess liquidity.
What I would say is that if you are in an accommodative monetary policy stance then the preference should be to give system more liquidity rather than less liquidity. So that even if you err a little bit in your calculations, if the system is surplus then the ability of the system to sort of carry forward the accommodative monetary policy stance into the rates of economy is that much more higher. That is the difference here. The point is that the RBI has been waiting a little longer in terms of providing that liquidity than probably the accommodative monetary policy stance would have warranted.
Q: I assume that this is your argument as well -- it is not a question of how deficit it is, the point is the RBI should never be in a deficit mode that we should be operating at the reverse repo window, at a time when the RBI is in accommodative stance, is that your point?
Dave: I think there are schools of thought whether you can have surplus liquidity without the operating rate becoming the reverse repo rate and now the RBI has various tools. Earlier on three-four years back the RBI did not have tools. So either it was reverse repo rate or repo rate or MSF rate, now they do have this thing called a variable rate repo and variable rate reverse repos.
So as I mentioned earlier, once you are relatively clear that the stapermate of the monetary cycle merits a much easier liquidity condition as in defined as not a deficit of 0.50 to 1 percent but a surplus of half a percent but you don’t want that half a percent to go to reverse repo rate for whatever reasons. That is a point of a separate discussion.
To come back to the point you were making earlier, I think at least looking at the data that I have gone through it does appear that there was a certain degree of assumption that there would be an increase in the forex assets because that is how it had been working for most of 2014 and first half of 2015. That switched off from the original Chinese devaluation date of August and that is what is causing this sudden widening of the gap between the total borrowing of the system from the RBI, which is around Rs 2,30,000-2,40,000 crore and the government balance, which is around Rs 160,000 crore. This differential to me is simply the loss of permanent liquidity over the last 12 months or so.
Q: Will it not be a problem in terms of the RBI endangering the system with too much of liquidity? If it were to bring the system to a square position, that is banks are borrowing maximum Rs 5,000 crore net or lending the system Rs 5,000 crore then you will have to provide liquidity to the extent of Rs 1 lakh crore. The Urjit Patel report indicates very clearly that when the system was printing notes or doing OMOs with greater regularity as it did in the period from 2010 to 2012, we ended up having double digit inflation, so while the impact may not be immediate, we may pay the price in the coming year, is not that a fair argument?
Dave: I cannot agree with you on this point. I think we are talking about a system, which will borrow when the government\\'s balance is zero about Rs 80,000-90,000 crore, which will borrow Rs 30,000-40,000 crore when RBI is at the peak of its Ways and Means Advances (WMA) drawdown -- the 50,000 limit which has been set two days back or so.
So, we are far from our system which is going to be flooded with liquidity. Flooded with liquidity is if there is so much money in the interbank system and there are not enough assets and we are giving it back at the reserve repo rate, if the money goes back to the central bank counters everyday through a variable rate reverse repo operation, I am not able to understand at least how that suddenly -- that in a banking system of Rs 90 lakh crore if you have Rs 40,000 crore which is less than half a percent or something which is given back to RBI, how that tail will wag the inflation dog so much. I am not entirely aligned to that school of thought.
_PAGEBREAK_Q: You were saying that we are very far from a surplus liquidity situation. My point is that if the RBI were to go ahead and do OMOs to the extent of the deficit, which is 1.5 lakh crore, by the time it works its way into the system, it may be very difficult to control the M3 at a later stage. Your point.