Credit Policy: Tight liquidity explained

On one hand, the RBI has streamlined computation of banks’ cost of funds, to ensure quicker transmission of policy rates, while on the other it has failed to announce any substantial measure to address concerns of tight liquidity conditions, which is equally critical for softer rates.

Banks have always been tardy in passing on policy rate actions. One of the main reasons for this has been the liquidity situation. If banks are short of funds to lend, they will be forced to raise interest rates to woo depositors. Thus, they may not be able to respond to RBI’s signals.

In a falling rate cycle, banks cannot be expected to pass on the rate cuts if liquidity in the system is tight.

To tackle some of these issues, the RBI introduced a new tool for short-term borrowing by banks — term repo — in 2013. Instead of providing funds at a fixed rate (repo), the RBI auctioned off the funds, with banks bidding for the rates at which they would borrow. By providing funds at market-determined rates, the RBI can control both the liquidity as well as the rate at which it provides such funds.

But this has led to banks facing an unusual liquidity situation. This is because the central bank has essentially done away with the window where banks could borrow any amount at a fixed price. The RBI has capped the amount banks could borrow under the fixed repo window to 0.25 per cent of their deposits. The shortfall is made good by term repo auctions.

Banks are also burdened with more stringent cash reserve ratio (CRR) requirements. Banks need to maintain cash with the RBI on a daily basis. Based on the current CRR requirement, which is 4 per cent, what banks need to set aside is calculated on a fortnightly basis. Each bank earlier needed to maintain at least 70 per cent of this amount on a daily basis. By the end of the fortnight, they should have met the overall 4 per cent requirement. From 2013, banks need to maintain 95 per cent of the requirement on a daily basis.

Micromanagement of liquidity by the RBI, according to market players, has left banks with less leeway to cut deposit rates, because prospective liquidity condition is equally vital. If banks feel that liquidity may tighten in future, then they will still be reluctant to cut deposit rates.

Hence, for a while, banks have been clamouring for CRR cuts or easing of the daily requirement. But the RBI has indicated that the on-going liquidity squeeze is more temporary and seasonal than structural. Hence, CRR cuts, much to banks’ disappointment, looks unlikely in the near term.

Banks’ short-term borrowing through the fixed repo and term repo window has been trending higher in recent weeks. One of the key drivers for liquidity deficit has been the slower government spending and loss on currency circulation. The RBI has indicated that the liquidity deficit remains within 1 per cent of net demand and time liabilities (NDTL) and it will look at various instruments to tackle liquidity deficit. The RBI is likely to manage liquidity deficit by introducing longer-term repos.

The RBI has been following the term repo route to infuse liquidity into the system through most of this fiscal. It may look at longer duration measures for assuaging liquidity concerns, such as open market operations (OMOs) — buying of government bonds, which will also help in creating permanent liquidity. So far this year, the RBI has conducted only two OMOs — to the tune of ₹10,000 crore each in December and January.

OMOs can also help suck the excess supply of government bonds. This can lead to bond prices moving up and yields trending down. The yield on the 10-year government bond has remained high at 7.7 per cent through most of last year, nearly 1 percentage point higher than the policy repo rate at 6.75 per cent.

Bond yields moving lower are also critical for better pass-through of RBI’s policy rates. As stated in the Urjit Patel Committee report, aligning interest rates across different segments to market-determined rates will facilitate the transmission of policy rates across segments.

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