The Reserve Bank of India’s liquidity stance has not convinced several experts, including even a member of the Monetary Policy Committee. What is it that the RBI is doing with liquidity, and why is it affecting the market. ET explains:
What is the RBI’s approach towards liquidity management?
The central bank follows a “corridor” liquidity management system – with a ceiling and a floor rate – where the repo rate–the rate at which the RBI injects liquidity–is the policy rate which acts as the ceiling for the corridor, while the reverse repo rate works as the floor of the corridor. The ideal situation is one where call rates move within this corridor which the central bank ensures through its liquidity adjustment facility (LAF). The operating framework of monetary policy aims at aligning the weighted average call rate (WACR) with the policy repo rate through proactive liquidity management to facilitate transmission of repo rate changes through the entire financial system.
How does this work?
Banks try to borrow their shortfall of reserves from the inter-bank market. If reserve requirements like cash reserve ratio and statutory liquidity ratio cannot be met in the inter-bank market, then banks borrow funds from the RBI under LAF. If banks are net borrowers under LAF, the system liquidity can be said to be in deficit. Conversely, if banks deposit more than the reserve requirement, then it becomes a net lender to RBI, and the system liquidity can be said to be in surplus.
What are the key drivers of liquidity?
The three major drivers of liquidity are the government’s cash balances with RBI, changes in currency in circulation in the system, and the central bank’s forex operations. RBI’s market operations or cash reserve ratio changes besides the monetary policy stance (through its liquidity operations) also tends to influence liquidity level in the system.
What has led to recent tightness in liquidity in the system?
When Covid-19 hit the economy in 2020-21, RBI made sure there was ample liquidity to support businesses hit by the pandemic besides adopting an accommodative policy stance, which led to surplus liquidity in the system. But, over the last two years, several factors have led to tight liquidity conditions. This included withdrawal of accommodative stance resulting in a lesser infusion of liquidity. Also, credit growth has surpassed deposit growth, causing fund constraints while government spending also slowed. Post the outbreak of the Ukraine war, India’s forex reserves too shrank, impacting rupee liquidity as the RBI had to sell dollars to stabilise the rupee. Reserves have started improving over the past six months with last year’s withdrawal of Rs 2,000 notes also having an impact.How has RBI reacted?
Over the last two months, the central bank has fine tuned its liquidity operations to ease the liquidity deficit. On average, the RBI injected Rs 1.6 lakh crore worth liquidity.
Has it helped?
Though liquidity tightness has eased, the call money is still trending marginally above the repo rate. Goldman Sachs in a report has suggested measures like longer-term repo operations when government cash balances build up and spreading out government borrowing to smoothen cash holdings besides incentivising banks to grow reliance on the inter-bank market than the RBI for daily liquidity needs.
