Time the RBI started mopping-up operations

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The spectre of drought looms large following the weak monsoon, and food prices are spiralling. The economy is awash with liquidity and further quantitative easing is clearly not advisable. It is time the RBI begins the process of tightening liquidity, says A. SESHAN.

The Reserve Bank of India (RBI) is supporting market borrowings of the Government in the first half of the current financial year. It has undertaken a massive responsibility to relieve pressure on interest rates. Before each flotation of new securities, it buys the old ones, thus releasing funds to banks to facilitate their purchase, the proceeds of which accrue to government.

Till August 20, such purchases were made to the extent of Rs 41,806 crore, a record under its so-called Open Market Operations (OMO). There was a specious or spurious argument by the Government that it did not constitute a monetisation of fiscal deficit.

Enough has been said by experts to educate the concerned officials on the manner of calculating net RBI credit to the Government, which implies deficit financing by the central bank.

After keeping a coy and discreet silence on the controversy, the central bank has more or less acknowledged the true nature of its support to government. (See the RBI Governor’s thought-provoking Tata Memorial Lecture on July 31, 2009 on the apex bank’s Website.)

The procedure is flawed as it violates the spirit of the Fiscal Responsibility and Budget Management Act (FRBMA), which prohibits any support from the central bank to the Government in the primary market for securities.


There are many incongruities in the current situation. In the first place, despite the RBI support, interest rates in the bond market are rising. Of course, the usual no-brainer counter-argument in such cases is that, but for the support, interest rates would have gone up even more.

But the anomaly comes out glaringly when one looks at the massive amount of reverse repo (RR) transactions of banks continuously with the central bank from the beginning of the financial year amounting to more than Rs 1 lakh crore, and representing the surplus liquidity available in the system.

Globally, there are moves on unwinding the liquidity unleashed in the last two years. The interesting point is most of the developed economies are still in recession whereas in our country the debate is on the level of the growth rate. The unsatisfactory South-West monsoon season has done enough damage to agriculture that cannot be undone easily even if it rains heavily in the remaining few weeks of the season. The hope is now on the rabi season.

Monsoon perils

But it needs to be remembered that, given the low proportion of cultivated area that has irrigation facilities, the success of agriculture in the rabi season in rain-fed areas depends on the moisture left behind by the SW Monsoon.

This is what this writer learnt from farmers during his rural credit surveys in West Dinajpur (West Bengal) and other places while working in the RBI.

So we have to depend on the irrigated lands of Punjab, Haryana and parts of Uttar Pradesh to make up for the loss of crops in the kharif season. They grow wheat during the rabi season. Thus, the compensation for the loss of the kharif rice crop may not be adequate. Food prices have been on the rise. The prices of pulses, vegetables and fruits have shot up. The lowly capsicum costs Rs 30 a piece in Mumbai! A mango is now a luxury for the aam aadmi!

Dairies in Mumbai have announced an increase of Rs 2 per litre of milk from the beginning of August. Restaurants have followed suit. There are reports of similar price increases in other centres also.

The Government says it has enough food-stocks to take care of the problem. It has been saying this for a long time, but the situation is only worsening. Despite the burgeoning buffer stocks, the price of rice recorded an increase of 15.4 per cent over the year, as on August 8, according to the Index Number of Wholesale prices.

With the grim scenario of double-digit inflation, the RBI needs to take a fresh look at its support to Government through monetary expansion. (The framers of law had the foresight to incorporate a provision in the FRBMA that it is not justiciable!) Banks say that there is a lack of demand for credit from manufacturers. The market, comprising predominantly of banks, does not have a good appetite for long-term securities now because of the perceived risk of interest rates rising and securities depreciating.

There are reports that many banks have reached the mandatory limits for securities in the ‘Held to Maturity’ category that do not call for marking to market. This is an additional factor unfavourable to the saleability of long-term gilts.

It is a buyers’ market with the (SLR) investment-deposit ratio of banks being 32.8 per cent, as on July 31against the statutory requirement of 24 per cent. Under the circumstances, the banks will try to maximise their incomes through treasury operations.

They can quote high prices for securities when they sell them to the RBI in its Debt Management Operations (DMO), euphemistically called OMO, and then try to buy them low when new bonds are floated — a prediction that has come true.

The Table on the DMO/OMO operations in respect of comparable securities in the recent period brings out this point. A review of the purchases of the RBI during April-August 2009 reveals that most of the time it had to reject a major percentage of the bids obviously due to unacceptable quotes.

Of the total of Rs 61,500 crore of securities intended for purchase during the period, the actual amounted to Rs 41,806 crore or about two-thirds. Two more auctions for the buy-back of a total of Rs 12,000 crore of securities remain in the first half of the year. Even if one assumes they will be ‘successful’, the achievement in purchases would work out to only 67 per cent of the target of Rs 80,000 crore.

Through clever and unacceptable bids at auctions, banks have frustrated the intention of the RBI to flood the economy with cash! The country owes a debt of gratitude to them.

No More DMO

The RBI should desist from any more DMO in the second half of the year. It should try to mop up the surplus funds of RRs through the gilt sales in the primary market. It should review its operations and find out what it has achieved for itself or the country, except perhaps for the incurring of capital losses in its consolidated balance sheet and that of the Government.

The economy is swimming in liquidity and may drown out of sheer inflation fatigue, if any further quantitative easing is undertaken. If interest rates rise, so be it.

The RBI can thus demonstrate that there is no conflict of interest in its handling of both monetary policy and public debt operations. In any case, if a shortage of liquidity emerges, the central bank can always take ameliorative action without loss of time.

(The author is an economic consultant based in Mumbai.

Related Stories:
‘RBI may stand pat for now, but tighten sooner’
RBI may review easy money policy

(This article was published in the Business Line print edition dated August 27, 2009)
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