Is there a shortage of liquidity in the system, as suggested by newspaper headlines? The problem is that we do not have an official definition of liquidity. Apart from the central bank's transactions under Liquidity Adjustment Facility (LAF) and Market Stabilisation Scheme and with the government, the concept of liquidity should include bank investments qualifying for the Statutory Liquidity Ratio (SLR) and in Mutual Funds (MFs).

In the case of MFs, the frequent round-tripping of funds between them and the banks creates its own multiplier effect. Since the announcement of the Annual Review of the RBI on May 3, a new LAF order has been ushered in. Repos, reverse repos and marginal standing facility (MSF) carry interest rates of 7.25 per cent, 6.25 per cent and 8.25 per cent, respectively. An indicator of liquidity is provided by the trends in the call money rates.

USE OF REPO FUNDS

In the first place, despite the talk about shortage, the weighted average call money rate has generally been between the repo rate and the MSF rate, the highest so far being 7.40 per cent.

Second, there has been no transaction whatsoever in the MSF. Obviously, there is not that severe a shortage to necessitate a resort to high-cost financial support from the central bank.

Third, the bid-cover ratio in the auctions of securities has been above two, indicating a good response. Fourth, and more interestingly, the repo window has been heavily drawn on by the system.

On June 7, it amounted to Rs 78,030 crore. How does one interpret it? For the system, the SLR was nearly 6 per cent more than the required legal minimum, as on May 20, 2011. Obviously, there are banks with surplus securities that can draw money from RBI's repo window and lend it in the call money market. Such arbitrage profit is not considered objectionable. According to the RBI, using repo funds in the call money market is part of normal inter-bank transactions.

I enquired with the Bank of England, the European Central Bank and the US Fed as to the permissibility of repo funds borrowed being on-lent. The first two indicated that there was no prohibition of this practice. The US Fed has passed on the query from one unit to another and I am yet to get a reply even after a month. The replies of the first two banks may provide some comfort to the RBI on its own stand. But there is a caveat. The Western central banks do not have any SLR and hence the type of situation observed in India does not obtain there. Repo lending is created money and, at a time of tightening, banks with surplus securities borrowing from the central bank for on-lending to others constitutes a leakage in the administration of the policy.

SKEWED FUNDS DISTRIBUTION

Will there be a severe shortage of liquidity in the second half of this month? In the first place, there will be advance tax payments by the middle of June that may drain out anywhere between Rs 40,000-Rs 50,000 crore from the system. Secondly, in June, large amounts of Certificates of Deposits are expected to mature.

The estimates range from Rs 50,000-1 lakh crore. CD rates are already hardening. Thirdly, the trends in Overnight Index Swap (OIS) market points to the possibility of the hardening of the short-term rates.

As on May 27, 2011, the Government of India had borrowed Rs 9,544 crore from the RBI. The access to the RBI under the Ways and Means Advance (WAMA) facility during April/May was attributed to the large-scale refunds of income tax, reflecting a lack of coordination between the relevant wings of Government in drawing up cash flow statements, and unsatisfactory financial planning.

Banks will be able to roll over the CDs with attractive interest rates. Their investment in MFs, as on May 20, 2011, amounted to Rs. 1,06,233 crore recording an increase of Rs. 58,630 crore in the current financial year. Banks have been given time to bring them down to a specified level in terms of net worth. Meanwhile, the Government continues to spend.

The problem facing the money market is really not one of shortage. It is one of skewed distribution of funds that banks with surplus liquidity are exploiting. Under the earlier arrangement, banks that were hard-pressed in the utilisation of the repo window were excused for deficiencies up to one two percentage points in the SLR.

The idea of tightening the flow of resources through a penal rate under MSF has not worked. Year-on-year bank credit rose by 22.3 per cent, on May 20, against 18.1 per cent in the previous year.

OPTIONS BEFORE RBI

Official soothsayers are predicting a fall in inflation rate, though the timing differs from one to the other. If so, the RBI may wait for the next quarterly review before making any changes in policy rates, as trends in the economy following the setting in of the monsoon will be known by then.

If there is a real liquidity crunch, the RBI may resort to Debt Management Operations through buy-backs of government securities to facilitate subscriptions to new floatations. There is also unutilised WAMA available to government to the extent of about Rs 35,000 crore till June 30, 2011, and Rs 20,000 crore subsequently till September 30.

(The author is a Mumbai-based economic consultant. >blfeedback@thehindu.co.in )

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