The Monetary Policy Committee has maintained a pause in interest rate hikes as per street expectations. But a deep dive into the change in its policy priorities indicates a clear rise in liquidity risks.
A seminal shift in the current monetary policy review is MPC’s priority to chase an inflation target of 4 per cent on a durable basis instead of the 2-6 per cent band. Meanwhile, the front-loaded rate hike by 250 basis points since May 2022 is still working its way towards full transmission of interest rate hikes.
The fluctuations in inflation between April-August show that there are various factors beyond liquidity management in controlling inflation. The spurt in tomato prices and their eventual correction shows that the spike was due to supply-side disruption.
Inflation worries
In a large economy with diverse geographies, seamless production, and distribution of commodities to check price rise needs the firm resolution to control inflation at various other levels that may not be under RBI’s control.
The RBI is focused on the withdrawal of accommodation to ensure that inflation progressively aligns with the target, while supporting growth.
Meanwhile, with elevated repo rates, input prices are likely to rise. Moreover, structural liquidity gaps in certain near-term time buckets may tend to widen exacerbating liquidity risk. Some banks may tolerate wider liquidity gaps to use arbitrage opportunities to book profits.
Amidst a rising interest rate curve, the cost of deposits will remain higher than the rise in the risk-adjusted yield on advances.
The tendency of drawings against marginal standing facility (MSF) is an indicator of rising liquidity stress, more importantly, after I-CRR was imposed. Liquidity position may ease after I-CRR is lifted. The tightened liquidity conditions are also evident from the fact that weighted average call rates moved up from 6.48 per cent in July to 6.58 per cent in August and further to 6.65 per cent in September.
Household indebtedness
The recent RBI data indicates that the net financial savings of households plunged by close to 55 per cent in FY23 scaling it down to 5.1 per cent of GDP, and their indebtedness more than doubled to ₹15.6-lakh crore from FY21, primarily led by massive borrowings from banks. Bank deposits may slow while other forms of investments may look attractive for savers who have already a low propensity to save. These trends indicate a further possible build-up of liquidity crunch. Banks should, therefore, tread cautiously in managing liquidity risks by balancing the risk-adjusted pricing of assets and liability to protect profitability.
The RBI has been alerting the banking system against risks of concentration of exposure to retail and unsecured assets. Due to higher servicing costs of low-ticket retail loans and lower risk-adjusted return, the portfolio may eventually exacerbate credit risk. Lenders have to be sensitive toward the sectoral mix of credit portfolios.
Any shift in the composition of the assets and liability mix is a long-drawn process which needs to be done quickly. To achieve 4 per cent inflation target, RBI has to align liquidity supplies accordingly.
In the process, banks will have to focus more on mitigating liquidity risks while balancing costs.
The writer is an Adjunct Professor at, the Institute of Insurance and Risk Management – IIRM, Hyderabad. Views expressed are personal
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