RBI must drain out excess liquidity

From the ravages of Covid-19, the global recovery in 2021 has been largely policy-driven. Public policy support — both fiscal and monetary — remains unprecedented. The unintended consequences of the ultra-loose public policy have been two-fold. First, the global asset prices have surpassed the pre-Covid level despite weak growth impulses. And, second, retail inflation globally has accelerated beyond the comfort zone of many central banks.

Although hesitant to prematurely withdraw accommodative monetary policy, many central banks have started contemplating an exit plan without disrupting the growth recovery. Notable among them is the US Fed, which projects at least 50 basis points (bps) increase in the Fed rate in 2023. If the US retail inflation, which remains above 5 per cent since May 2021 — the highest in the last three decades — persists for a longer period, it would not be surprising for the Federal Open Market Committee (FOMC) to advance the Fed rate hike to 2022.

To begin with, the Fed has to progressively taper the bond-buying programme — currently $120 billion per month, failing which the rate hike would not be effective. Incidentally, the balance sheet of the US Fed, which was below $4 trillion before the pandemic, has surpassed $8 trillion.

Like the US Fed, several leading central banks are the prisoners of their own creation. The Bank of England and the European Central Bank may have to follow the US Fed in a highly integrated global financial system as their current CPI inflation is well above 2 per cent. Pumping excess liquidity initially pushed up asset prices, not only in their own countries, but also in other jurisdictions. The spillover from asset prices seems to have started in the commodity prices, similar to the experience witnessed during the global financial crisis in 2007-08.

India’s growth-inflation dynamics has been evolving broadly on similar lines. Growth impulses are weak, which need policy support for some more time, while inflationary pressures have built-up in almost all segments of the CPI basket. Despite the high base, the CPI inflation remained elevated around 6.3 per cent in May-June, before softening to 5.6 per cent in July 2021. As the CPI index is rising sequentially (July over June), it cannot be wished away as transitory hump. The WPI inflation at double digit level has been alarming since April 2021.

RBI’s policies

Since the beginning of 2020, the RBI has been pursuing both conventional and unconventional monetary policy to fight against the impact of the pandemic. While the repo rate setting by the Monetary Policy Committee (MPC) is a part of the conventional monetary policy, RBI’s long-term asset purchases broadly correspond to the quantitative easing followed by the developed countries.

Besides the 115 basis points (bps) cut in the repo rate since March 2020, the RBI has been buying both domestic and foreign assets under different schemes, providing refinance to all-India financial institutions and additional SLR exemption to accommodate banks under Marginal Standing Facility.

In FY21, injection of liquidity announced by the RBI was ₹13.6 trillion, of which, ₹8.9 trillion was absorbed and the balance (₹4.7 trillion) returned to the RBI under the reverse repo deposit. Due to the Covid second wave, the RBI announced asset purchases (₹2.2 trillion) under the Government Securities Acquisition Programmes (GSAPs 1 and 2) in H1 FY22.

Including foreign asset purchases of ₹4.5 trillion up to August 6, 2021, total liquidity injection during H1 FY22 so far, has been about ₹6.7 trillion of which market has roughly used ₹4 trillion. The RBI’s ultra-loose monetary policy is evidenced by ₹7.4 trillion net absorption of liquidity under reverse repo as on August 13. The repo rate set by the MPC is currently not the effective policy rate, as the RBI’s large quantitative easing has pushed the weighted average call money rate — the operating target of RBI’s monetary policy — below the reverse repo rate together with other overnight rates. As the inflationary pressures have built-up, the RBI has to change the gear and normalise its monetary policy in a non-disruptive manner in H2 FY22. This is not possible without draining at least 75 per cent of the excess liquidity. A beginning was made by restoring the cash reserve ratio (CRR) to 4 per cent in two phases.

The effort to reduce excess liquidity was aborted due to emergence of the Covid second wave in Q1 FY22. Since the credit growth is still subdued, the RBI is not in a position to hike the reverse repo rate (currently 65 bps below the repo rate) to restore the corridor, which was +/-25 bps around the repo rate before the pandemic.

The process of rewarding banks have started by conducting 14-day reverse repo auctions amounting to ₹2 trillion in Q1 FY22, which would be doubled to ₹4 trillion in Q2 FY22.

Moreover, banks that extend additional loans to MSMEs are allowed to deposit their excess liquidity (up to the additional loan amount) at repo rate minus 25 bps. Besides 14-day reverse-repo auctions, the RBI has to sell dollar opportunistically to reduce excess liquidity and pep-up overnight rates. This would help the RBI hike the reverse repo rate and restore the policy corridor anytime in H2 FY22.

Benchmark yield

The RBI has been successful in managing the benchmark 10-year yield around 6 per cent so far by injecting excess liquidity to the system, which would not be possible going forward. The RBI has softened its stand to maintain the benchmark yield at 6 per cent. While the draining of excess liquidity has started, normalisation of monetary policy is the next move, at least a neutral monetary policy by Q4 FY22.

Incidentally, one MPC member dissented about pursuing an accommodative monetary policy further in the August meeting. Inflation targeting central banks like the RBI are facing severe conflict in controlling inflation and debt management when the fiscal deficit is high.

The writer is former Principal Advisor and Head of the Monetary Policy Department of RBI

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