The October 8 monetary policy statement sent a mixed signal about the Reserve Bank of India (RBI)’s approach towards liquidity management. While the RBI seemed concerned about the surplus liquidity in the financial system, it was not clear what it plans to do about it. The communication highlighted the conundrum that the RBI faces regarding management of excess liquidity.
Since the start of the COVID-19 pandemic, the RBI has injected massive amounts of liquidity into the system through various schemes, including for the first time, pre-committed to buy government securities (G-Secs) under the G-Sec Acquisition Programme (GSAP). As of now, the surplus liquidity in the system is around Rs 13 trillion.
The RBI should be worried about how to absorb the excess liquidity due to three main reasons — all related to inflation. In September, CPI (consumer price index) inflation was 4.35 percent, which was close to the target of the 4 percent. If inflation remains low, then liquidity can remain easy for a longer period.
However, scenarios with rising inflation seem quite plausible now.
First, inflation in India has not yet been conquered. Core inflation (i.e. non-food, non-fuel inflation) was 6 percent in September, and has been persistently high and sticky for months (see graph below). Core inflation has been stubborn despite the negative impact of the pandemic on aggregate demand, and very low credit growth. As India comes out of the pandemic, the aggregate demand will only increase, thereby putting further pressure on inflation.
Second, the economy is facing an acute energy crisis with coal shortages, and rising global crude oil prices. The price crude oil has increased 122 percent, from $37 per barrel in June 2020 to $81 in October 2021. High fuel prices will feed back into overall inflation. Further, worsening coal shortages will aggravate supply side constraints, and push up the price of electricity, thereby pushing up inflation. We are yet to feel the full impact of this energy crisis.
Third, there is a big risk that we are entering a new phase of global inflation. As the advanced economies recover from the pandemic, and simultaneously experience prolonged supply bottlenecks in an environment of easy money, the era of low inflation seems to be over. If that is indeed the case, India cannot remain insulated.
If inflation pressures keep rising, at some point the RBI will need to withdraw the excess liquidity. While it is relatively easy for a central bank to infuse abundant liquidity, it is significantly harder to come out of it.
On October 8, RBI Governor Shaktikanta Das announced that the RBI will be conducting 14-day variable reverse repo rate (VRRR) auctions on a fortnightly basis. This means that the RBI will be absorbing some amount of the excess liquidity from the financial system on a short-term basis for 14-days at a rate decided in the auctions. This strategy will move liquidity from an overnight window (in case of absorption at the reverse repo rate) to a longer 14-day window. However, it is not clear from the RBI’s statement, what is their plan going forward to take out the liquidity structurally, and permanently, from the system. The VRRR alone is not sufficient to normalise the liquidity situation.
The RBI has suspended its GSAP programme for now. Technically it could conduct a reverse GSAP i.e. it could sell the G-Secs in order to bring the liquidity levels down. This can run into two problems.
First, banks would typically be the ones to buy, but banks are already holding much more than the minimum statutory requirement of holding G-Secs (i.e. the SLR norms). Further, as commercial credit picks up with normalising economy, such actions may crowd out private credit. Banks, focused on maintaining their spreads i.e. the difference between what they pay the depositors, and what they earn on their loans and investments will be reluctant to excessively invest in G-Secs — the lowest yielding investments, as it hurts profitability.
Second, any attempt by the RBI to reduce liquidity will inevitably lead to high G-Sec yields, and push up effective interest rates in the economy. This in turn will worsen the government’s budgetary position given that it is already struggling to finance an unprecedented level of debt.
The natural solution in the short term could be a compromise: withdraw some liquidity but not a whole lot. However, if inflation continues to rise, the RBI will be left with very little choice. If it does not act promptly, then, to normalise the liquidity situation, inflation would get worse, which in turn will force the RBI to raise rates; and if it does try to absorb the excess liquidity, interest rates will go up.
In other words, the very objective of the RBI’s liquidity injection policy of keeping interest rates down, may not be met beyond a few more months.