Talking Point. The right tool to manage liquidity

The RBI’s Annual Monetary Policy meeting has always been critical in terms of setting up expectations based on forward looking guidance and policy pertaining to the banking sector and the financial markets.

This time, the underlying determining factors related to policy have been quite favourable for the RBI.

The biggest comfort that the Monetary Policy Committee (MPC) members can draw is that the effectiveness of interest rate as the first line of defence for currency has been proved again, with the gain in currency.

After the RBI changed its stance, from accommodative to neutral, in the February policy, the rates in the fixed income market have inched up and encouraged foreign portfolio investments (FPI) to look at India after shying away in the preceding months.

The decision is also commendable as it indicates that the RBI anticipated the moves of other central banks across the world.

Globally, central banks are shifting policy gears towards neutral, in order to create more room to manoeuvre in either direction. The changes are possibly due to emerging fiscal and political uncertainties, the known-unknown conundrums.

The shifting stance from accommodative to neutral emphasises that the central bank is moving to reactive rather than proactive mode, giving precedence to ex-post rather than ex-ante factors.

The US Fed, in its March policy, has changed its future guidance from “only gradual” to ‘gradual’, from narrowed down one option to broad-based approach. The Bank of England had already highlighted openness to interest rate direction either way. And the European Central Bank does not show a totally different trend.

Now for the next policy. The overnight rate (O/N) has been trading significantly below the policy rates, against the RBI’s stated objectives. The sloshing systemic liquidity (over ₹4 lakh crore currently) is unlikely to go away any time soon.

Interestingly, during the December 2016-January 2017 period, when systemic liquidity was much higher, overnight rates were close to repo rate. On the contrary, now the liquidity is much lower than that period but overnight rates are well below policy rates. So what has changed?

The RBI was sterilising liquidity with the combination of liquidity adjustment facility (LAF) and cash management bills (CMB) during November 2016-January 2017. The LAF facility is only available to commercial banks and primary dealers, whereas CMBs are for everyone.

The CMB was part of the market stabilisation scheme (MSS), where the RBI sterilises liquidity through auction of short-term securities, invested by any entity. This mechanism allows non-bank entities to park excess liquidity with the RBI, to strengthen the sterilisation process.

The RBI has stopped issuing CMB since January; as a consequence, the direct interaction between the RBI and non-bank entities in the liquidity channel has stopped.

Moreover, mutual funds are facing difficulties as there have not been many avenues available to park their short-term flows.

The major thrust of the RBI now is to clear market speculation by communicating proper tools and timing. In reality, the classic problem faced by central banks is not the action but choosing appropriate tools.

Reports have been doing the rounds regarding introduction of the standing deposit facility (SDF). The SDF was mooted by the Urjit Patel Committee in 2014, as a substitute to the reverse repo that can absorb surplus liquidity without any collateral.

Collateral is critical when the central bank is running out of securities while managing excessive liquidity, and this is certainly not the case currently.

Moreover, if SDF is designed with lower interest rate than the reverse repo, it will actually open up a four-tier corridor approach from the three-tier corridor approache currently. The LAF window consists of three — repo is at the pivot level and two penal rates are at a lower and higher level.

But will SDF solve the problem? If SDF offers lower rate of interest, then banks are unlikely to park money in lower yielding SDF, unless forced by way of restricting access to reverse repo. But even then, the overnight rates will likely remain lower than policy rates, a continuation of the current condition.

The other option is taking recourse to conventional tools like cash reserve ratio (CRR). A hike in CRR will damage transmission not only in the banking channel but also the assets market. Moreover, the liquidity will slowly get absorbed in the system by itself in sync with improvement in economic activities in nominal terms.

Considering the above options, CMB appears to be a better tool in view of the RBI’s objective and functionalities. CMB is an option available for MF or any other entities, which gives them direct access to the RBI without expanding LAF corridor or cohorts of LAF eligible members.

The writer is Associate Director, India Ratings & Research, a Fitch Group Company

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