There seems to be a disconnect between what the RBI perceives as ample liquidity and the banking system’s reading of the same.
The prevailing liquidity situation determines the pace of policy transmission — this assumes importance in the current context, when banks are reluctant to cut lending rates after two successive rate cuts by the RBI since January.
Why it mattersIf banks are short of funds to lend, they will need to rely on more expensive market borrowings to fund their businesses.
Thus, they may choose not to respond to RBI’s signals. In a falling rate cycle, pass-through of rate cuts will happen only if there is sufficient liquidity in the system.
Banks have been lowering their rates on deposits across tenures over the last six months.
This should have given them enough headroom to lower the lending rates. But it appears that banks are faced with an unusual liquidity situation.
Banks used to source funds for their short term needs from the RBI at a fixed repo rate. But in October 2013, the RBI decided to move to the term repo mechanism as it didn’t want to extend unlimited funds to banks at a fixed rate.
The RBI capped the amount banks could borrow under the fixed repo window to 0.25 per cent of their deposits. The shortfall, if any, was made good by term repo auctions (conducted for seven and 14-day periods) held by the RBI.
So, banks now source overnight funds from these auctions by bidding at rates at which they would like to borrow.
During an interaction with analysts, after the monetary policy review, Raghuram Rajan stated that the disconnect in the perception of liquidity between banks and the RBI is a result of the central bank doing away with the windows where banks could borrow any amount of liquidity at a fixed price.
“As a result certain market players who used to finance themselves through our windows are finding it harder as they have to go to the markets to raise money,” he said.
The RBI’s intention to move away from the fixed repo rate was to ensure quicker transmission of policy rates.
By providing funds at market-determined rates, the RBI could control both the liquidity as well as the rate at which it provides such funds. By tweaking the amount of money it makes available through term repos, it has ensured that the rates on term repos are closely in sync with RBI’s policy rates. “We have tried to keep the market rates close to the repo rate by injecting enough liquidity. We have achieved a fair amount of narrowness in rates — the market rates now tend to hug the repo rate,” says Rajan.
But many market participants feel that by tweaking the amount of money it makes available through term repos, the RBI is keeping a tight leash on short-term rates in the economy. “Banks have to take a call. Our windows cannot be the primary source of borrowing for them. Banks have to find other ways of managing short-term liquidity requirement.
“To see that as the reason why banks are not cutting rates is not the right way to look at it,” added Rajan.