The unexpected flow of dollars under the foreign currency non-resident (bank) scheme likely prompted the RBI to terminate it by August. The total amount of around $127 billion helped foreign currency reserves to increase from $543 billion, before the scheme was announce, to $648 billion. This is the good part of the story. The conundrum relates to the deployment of the rupee funds that have been released due to the swap by banks with the RBI. This is an issue for not just banks but also the RBI as it involves market stability.
The rupee equivalent of the funds raised would be around Rs 12.2 lakh crore, on which an average of about 6.75% has been paid. The interest payment is not covered under the swap with the RBI. Hence, at a swap rate of 2.75-3%, the cost of around Rs 2,000-2,400 crore must be carried by banks for the next three to five years depending on the average tenure of these deposits, which must be factored in while pricing loans. The more interesting part is the parking of funds.
In the best-case scenario for banks, if the entire amount is deployed as credit there would be the maximum gain. At an average return of say 8.5% the return for the system would be 1.75%. Data of private banks on the weighted average lending rates for fresh loans shows they are even higher at 9%, which means the return can be 2.25% on such deposits.
However, it should be remembered that banks would be receiving domestic deposits in the normal course of business. Unlike bond issuances that have limits on how much can be raised, it is open-ended for bank deposits. An increase of around 12% in domestic deposits at a conservative level would have led to a flow of around Rs 31 lakh crore this year, which will now be around Rs 43 lakh crore (an increase of 16.5-17% for the year). Even if credit growth crosses 15-16%, the claim for funds would be up to around Rs 33-34 lakh crore. The system would still have a surplus of Rs 9-10 lakh crore. This is why some economists have flagged the need for banks to maintain the quality of assets. The tendency to push loans by compromising standards should be eschewed at any cost.
Managing the funds is a real challenge. The surpluses have revealed the following. Banks are not in favour of investing in variable rate reverse repo (VRRR) of longer duration (15-30 days). Because September is a busy month for tax outflows, banks may be cautious about locking funds for longer duration. Investing in overnight VRRR is preferred, but it is not an optimal permanent solution as the return is not more than 5.24% — much lower than the 6.75% at which funds have been garnered. A sustained deployment in such an option will mean a negative carry for banks.
One possibility on the discussion table in the market was the imposition of an incremental cash reserve ratio (CRR). While this is an option, it would run contrary to the sops attached when the scheme was announced (funds being free of CRR). Further, several banks have not procured these deposits in any significant measure as their reach is limited. By having an incremental CRR, banks would be penalised on domestic deposits. This would in turn put banks in a spot, and will be a lose-lose situation for the system.
The other possibility is open market operations (OMOs), which have been announced where government securities are sold to banks. The RBI holds around Rs 18 lakh crore of government papers and can easily offload them. It would mean a loss of revenue for the central bank, but a gain for banks. However, for banks, the return must be compared with the cost of 6.75%; else there will be a negative carry. This will be central to the success of OMOs.
From the market’s point of view, the continuous sale of government paper by a calendar will mean excess supply which will depress bond prices. As the price of bonds varies inversely with the interest rate, bond prices will decline with higher interest rates. This will mean all future government borrowings will be at higher cutoffs. While the aggregate amount may not be too large to absorb for the government, it will fuel a bond market sentiment of a rate hike in the immediate future. One can then expect yields to go up in anticipation.
An option that can be considered is to expedite the government borrowing programme in the second half so that the market sentiment is checked. But this will only defer the issue as domestic deposit flow would follow the normal course. This also means that even if the RBI decides to increase the repo rate based on the committee’s recommendations, deposit rates would not increase, and banks would persevere with the existing structure based on their asset liability management positions. This will come in the way of monetary transmission.
Thus, there is a question mark about how to manage liquidity in the domestic market resulting from an overwhelming flow of dollars. The fact that the economy is growing will mean steady demand for credit. But surpluses will remain and must be addressed. Getting in forex flows and maintaining liquidity at appropriate levels has implications for the bond market, which makes setting of interest rates even more interesting.
