The Hindu Business Line : On liquidity and interest rates

There could be a shortage of liquidity in the coming months, given the credit explosion and the Finance Minister cutting Government expenditure to reach his deficit goal.

It's still Monetary Policy season.

The RBI (predictably) raised the cost of borrowing from the central bank to 7.25 per cent from 7 per cent. It had no choice. Growth is strong as is credit expansion and asset price inflation is assuming runaway proportions.

For the first time, the reverse repo rate (what banks earn on funds placed with the RBI) was not increased in tandem with the rise in the repo rate. What (if any) is the significance of this departure from past practice? Is the reverse repo rate being marginalised? Will the RBI do away with the concept of the reverse repo rate altogether?

Underlying the issues is the relationship between the central bank's benchmark rate and system liquidity. In which direction does cause-effect run? Or are they independent of one another?

On several occasions in the past there has been a big disconnect between system liquidity and repo rates.

Big disconnect

Money rates shoot up, well beyond the RBI's lending rate, when the market is short of liquidity. At other times, when liquidity is plentiful, call rates are well below the reverse repo rate.

Both situations offer arbitrage opportunities to borrow from the RBI and lend in the market or borrow from the market and lend to the RBI. And neither is likely to find favour with Authority, for, in such situations, the anchor rates are not performing their function of controlling market rates.

In effect, the reverse repo and repo rates are more like caps and floors for money market rates, which is very different from being target rates. Indeed, at any point of time, depending on system liquidity, one of the rates is entirely dormant.

A couple of years back, when the market was flush with funds, the RBI innovated the issue of Market Stabilisation Scheme (MSS) bonds to absorb the excess liquidity. The prospect, in the coming months, is likely to be the opposite - there could be a shortage of liquidity, given the credit explosion and a fiscally `aware' and `responsible' Finance Minister cutting Government expenditure to reach his deficit goal.

How RBI will act

How, in the circumstances, will the RBI cool money rates if they soar beyond its benchmark, especially considering that banks are reducing their SLR portfolio to meet credit demand and also (equally important) minimise market risk (of which they have had plenty in recent years)? Their access to on-tap finance is low because their inventories of repoable securities (beyond the mandatory SLR of 25 per cent), which makes it possible to borrow from the central bank, is low.

One option for the RBI is to engage in dollar buying to improve market liquidity. With the rupee appreciating sharply of late, it may well opt for this route if market rates get out of hand. Another is to buy gilts in the hope that the infusion of liquidity will temper rates.

Liquidity power will vest with institutions and portfolios with eligible collateral. A crunch will see lending rates escalate significantly.

Keeping its benchmark rate meaningful and managing system liquidity will be no easy task in the next months.

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