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Thursday, Apr 01, 2004

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Market Stabilisation Bills/Bonds — Mopping up the excess liquidity

A. Vasudevan

The economy is awash with funds, and the Reserve Bank of India needs to mop it up. But the traditional methods may not be effective. Market Stabilisation Bills/Bonds are an option, says A. Vasudevan, but wants the RBI to encourage the Governme nt to contain the fiscal deficit and help implement other non-price measures such as capital account and trade liberalisation, and reduction of high-cost external debt obligations.

ONE WONDERS why so much time has been taken to state the operational procedures relating to the issue of absorption of excess liquidity that is generated by large capital inflows. Is it because of some critical comments on the question of issuing Market Stabilisation Bills/Bonds (MSB)?

The Reserve Bank of India will celebrate its birthday this month with a fairly large issue of Rs 5,000 crore under the MSB. This has given an impression that the liquidity absorption is vital in the next fiscal year, and not now.

This is unfortunate as there is little evidence of the abatement of capital inflows and there is no reason why there should have been such an implementation lag in policy.

It is, however, good that a good policy has eventually been announced. I believe that it would get the support from the urban and educated youth. This belief is based on the results of an assignment I gave in February to 40 M.A. students representing a cross section of the Indian society. Let me briefly give the results of the assignment.

The responses of the students are fascinating. Barring two students, 38 students opposed the use of the Cash Reserve Ratio (CRR) to suck liquidity. Of the 38, nine responses cautioned that the CRR should be used only as a last resort.

With the exception of one, all the students favoured the issuance of MSBs. In their view, MSBs should give an attractive yield rate and the government should bear the associated fiscal cost preferably through taxation. Thirty-one students wanted MSBs to be tradable. Receipts from the sale of MSBs were not to be used, although eight felt that they could be invested safely.

Thirty-six students took the view that the RBI should hold MSBs. According to them, once the excess liquidity position becomes normal, the central bank could treat the MSBs in its portfolio as regular Government of India securities and use them in open market operations (OMOs).

If MSBs were not to be issued, the alternative, according to 35 respondents, was to have special deposits with the RBI, obviously as a short-term measure, at an interest rate that would be, according to 30 students, higher than that on the longer of the treasury bills.

Almost all students favoured institutional measures such as liberalisation of trade and capital account, reduction of high-cost external debt and government financing on participation basis of major international projects funded largely by multilateral financial institutions.

Thirty-six students did not favour any dismantling of NRI schemes and preferred to at least let the current situation continue. Thirty-eight students did not want unbridled appreciation of the rupee and emphasised the need for RBI intervention to ensure that India's competitiveness is not lost.

Twenty-six students considered establishment of a contingency fund for South and South-East Asian countries to be of help in strengthening their capacities to prevent currency and financial crises. Finally, they regarded the need to have a multi-pronged rather than a single policy to absorb excess liquidity.

It is fine to have MSBs but by how much is critical. The RBI would have to not merely rely on LAF (liquidity adjustment facility) for very short-term modulation of liquidity but also on MSB approach at the system level to give confidence to investors that the liquidity problem would be soundly addressed.

My back-of-the-envelope calculation about excess liquidity is based on the belief that it is important to know in the first place how much of money is in excess of what is warranted by the growth in nominal GDP.

The policy-maker should have a medium-term real output growth projection and an inflation target. If the former is 6.0-6.5 per cent and the latter 4.0 per cent, the nominal GDP growth would be around 10.0-10.5 per cent.

For 2003-04, however, real income growth is placed at over 8.0 per cent, and the inflation rate to edge up to 4.5-5.0 per cent. On this basis, the nominal GDP should be 12.5-13.0 per cent.

M3 growth so far has been about 14.5 per cent but by the end of March 2004, it is bound to go up to 15.0-15.5 per cent. A broader liquidity measure could show a higher growth rate of 16.0-16.5 per cent. This would imply that there would be a gap of 3.5-4.0 percentage points between the liquidity growth and the expected nominal GDP growth of 12.5-13.0 per cent.

This gap in relation to the expected nominal GDP would work out to Rs 84,000-96, 000 crore. Taking the higher of the two figures as a safe proposition to aim at, one needs to see which of the policy instruments would be feasible.

Can CRR alone be used for absorbing such a large quantum of excess liquidity? With the outstanding aggregate deposits at about Rs 14,80,000 crore at end-February, absorbing excess liquidity of about Rs 96,000 crore would mean that CRR would have to be raised by over six percentage points over the present 4.5 per cent.

This is neither feasible nor desirable. Instead of CRR, if one were to use interest rate alone to absorb liquidity with a view to increasing domestic investment, one has to make an absurd assumption that investments are highly interest sensitive.

If this were to be true, the current soft interest rate regime would have to become softer. This may not be easily feasible because of the structural rigidities of the banking system.

Against this background, MSBs provide a way to move toward a prospective open market operations (OMO) route.

There are no doubt costs, mainly fiscal (the interest to be paid and the adverse expectations of investors due to the weakening of the fiscal position in future) but there are benefits too in that the incipient inflation on account of excess liquidity is reduced, besides keeping the stock of foreign exchange assets intact.

Investments of foreign assets may not fetch high returns but this could change if the expected recovery in the Western economies materialises. As receipts from MSBs are frozen, redemptions bear zero risk.

The RBI could auction somewhat longer-term repos against the outstanding MSBs in its portfolio to suck some liquidity.

The large excess liquidity however could complicate matters for the RBI if Government's market borrowing requirements in the next fiscal year are much larger than at present.

This would put an upward pressure on market interest rates. But the central bank should not take recourse to inferior alternatives such as special deposits with the RBI, a variant of CRR and issue its own securities.

It should encourage the Government to contain the fiscal deficit, and help implement other non-price measures such as capital account and trade liberalisation, and reduction of high-cost external debt obligations.

Also if needed, have either small hikes in CRR or small amounts of `special deposits'. Do not have one single policy: Use your discretion as a rule to have a multi-pronged policy but in a transparent manner.

(The author, a former Executive Director of the Reserve Bank of India, can be contacted at

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