Cash Flow: It’s game, set & match for RBI: Economic Times: 23rd February 2011

Liquidity has been a problem for banks throughout this year and the RBI has used various tools to maintain equilibrium. It has conducted aggressive Open Market Operations (OMOs) to provide liquidity as well as upped the LAF window for repo transactions. Also, the statutory liquidity ratio (SLR) has been reduced by 1% point. But the RBI has not relented on lowering the cash reserve ratio (CRR), which would have brought in around Rs 50,000 crore into the system. How do the constituents of the system stack up in this game?

The RBI, on an average, has provided around Rs 50,000 crore of repo money on a daily basis to banks. This number averaged Rs 85,000 crore since September. The actual repo cost to banks between April 1 and February 17 was Rs 1,925 crore. The RBI simply had to re-circulate the money that was provided to banks when required. Or more easily, it could have used the CRR balances with it.

OMOs so far this year were Rs 67,000 crore. Here, basically the RBI purchased securities and gave banks cash which they could use. Assuming that the average return on these securities is 7.5%, the RBI would now be paid interest by the government of nearly Rs 5,025 crore. Therefore, on the whole, the RBI is better-off by around Rs 7,000 crore. It has printed some additional currency, which is the only cost that has been incurred for this activity.

What about banks? Given the tight liquidity conditions, they had to bear the cost of repos which was Rs 1,925 crore. But in the OMOs, they parted with Rs 67,000 crore of securities and got cash for it. They could either reinvest the proceeds in GSecs or use it for commercial purposes. Reinvesting in GSecs would have given them, maybe, just a better return of 50 bps, given that rates have moved up during this year or Rs 335 crore (0.5% of Rs 67,000 crore). The alternative would be to channelise these resources into commercial lending, where the rate would be a minimum of 12% and they would have received at least 4.5% more than on GSecs. This would mean a gain of around Rs 3,015 crore. As money is fungible, one cannot really figure out which resources were channelised to which use.

Furthermore, the investment deposit ratio has come down by roughly 1% after the SLR was lowered. Essentially, around Rs 5,000 crore would have been released and assuming that it now earned the commercial rate, banks would have gained another Rs 225 core (4.5% of Rs 5,000 crore). Now, in net terms, the banks could have actually been better off by around Rs 1,300 crore (Rs 3,240 crore minus Rs 1,925 crore). Here, we are assuming that the repo money was not churned at 12%! If this was done, then banks could have earned higher returns, which the RBI has warned should not be happening.

The government is in an unchanged position because the RBI has dexterously steered the borrowing programme. The OMOs do not change the government’s stance as only the holder of the paper has changed. The cost to the government on account of change in ownership is nil as its own account is also not affected in any way by these transactions.

The borrowers would complain since they continued to pay higher interest rates, but then they were paying the price of capital as theory says that tight liquidity must get reflected in the cost of funds which went up, guided as it was by the RBI.

The alternative, as mentioned earlier, was to tinker with the CRR. A 1% reduction in CRR, would have released Rs 50,000 crore into the system. Here, the RBI would have eschewed the cost of printing more currency and handing it over to the banks. This money is anyway deposit money kept by the public which would have come back to banks. If this money were deployed commercially, banks would have earned up to Rs 6,000 crore on it, i.e. 12% on Rs 50,000 crore depending on what part went into commercial lending or GSecs (which would have earned say 8%).

How can all this be summed? It is a true Pareto optimal situation where all parties have gained or no one has lost. To borrow a simile from the tennis court, it is more like game, set and match to the RBI.