The liquidity deficit in the banking system rose to a 14-year-high of Rs 3.5 lakh crore on January 24 following the outflows from the banking system to make goods and services tax payments, according to experts.
Given the high deficit scenario, the Reserve Bank of India (RBI) held a variable rate repo (VRR) auction today to infuse Rs 2.5 lakh crore into the system. The central bank has been intervening in the money market with multiple instruments in recent months to manage the liquidity situation. The liquidity deficit in the banking system widened on January 24 to Rs 3.5 lakh crore, from Rs 3.34 lakh crore on January 23.
Here’s an explainer on how the central bank is managing the high deficit and its impact on short-term rates.
Why has the liquidity deficit hit a 14-year high?
Money market experts said that the liquidity deficit has widened this week to a 14-year high primarily because of GST outflows on January 20 and lower government spending.
Experts also added that the tight liquidity conditions reflect a pick-up in currency leakage from the festival season and less support from the Balance of Payments (BoP) surplus from Q2FY24.
As per a Kotak Mahindra Bank report, the outflows from the banking system were expected at Rs 1 lakh crore of GST, and Rs 86,300 crore worth of auction.
Also read: Market fall rooted in stock-specific negatives, not Sebi FPI disclosure norms
What is the impact on short-term rates because of the high deficit?
The higher deficit liquidity in the banking system has increased the short-term rates including call money rates, commercial papers, and certificates of deposits.
After tight liquidity, the weighted average call money rate was trading at 6.8565 percent on January 25, as compared to 6.83 percent during the early trading session on January 24.
Similarly, the yield on commercial papers maturing in three months rose 15-20 basis points (bps). On January 24, the cut-off yield on treasury bills also increased by 2-4 bps over the last week.
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How is the RBI managing tight liquidity?
The central bank has been actively managing tight liquidity by conducting various VRR auctions. In January, the central bank conducted five VRR auctions worth Rs 7 lakh crore. For these auctions, banks have shown heavy response and submitted more than twice bids but the central bank accepted only the amount close to the notified auction amount.
The central bank on January 25 conducted a 15-day VRR auction, in which banks submitted bids worth Rs 3,08,024 crore and the RBI only accepted bids worth Rs 2,50,010 crore at a 6.72 percent cut-off rate.
The central bank also has a liquidity window for the banks called Marginal Standing Facility (MSF), through which banks can borrow money from the central bank for one day.
Also read: Liquidity deficit in the banking system rises over 13-year high after tax outflows
Why does the RBI want to keep the liquidity tight?
Money market experts said that the tight liquidity keeps the overnight rates near MSF rates and helps the transmission of past rate hikes done by the RBI. Most experts believe that the central bank will continue to keep liquidity tight but will provide support whenever needed.
When are the liquidity conditions expected to improve?
The liquidity deficit is likely to narrow in the coming days after the start of government spending next week. Usually, in the last week of a month, government spending kicks in on account of salaries and pensions, which lifts liquidity in the banking system.
India Ratings in its note dated January 24 said an increase in FPI inflow owing to India’s inclusion in Global Bond Indices will improve the liquidity situation, while the surge in cash in circulation ahead of the parliamentary election will keep the RBI on its toes, notwithstanding the beginning of government spending in April 2024 and a relatively weak credit season.
“Also, given the expected large volatility in the banking system liquidity owing to the surge in FPI flows, a neutral stance will be appropriate to operate on both sides, e.g. infusion and absorption of durable liquidity,” the rating agency said.
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