Liquidity crunch was a blessing!: Economic Times 17th April 2019

FY19 has been a year of liquidity management when the central bank worked relentlessly to ensure that the rupee and interest rates remained stable amidst inflation volatility. At the end of the year, it has been a win-win situation for the government, RBI and banks as the liquidity issue was addressed more than adequately with the recent dollar swap being the surprise. The liquidity problem had its genesis in the phenomenon of bank deposits growing at a slower rate than bank credit. Deposits were affected on two scores. First, financial savings kept going down and second, due to low interest rates, households migrated to the capital markets with mutual funds being the beneficiary. The interesting fallout of a liquidity crunch is that the RBI intervened regularly in the market through LAF as well as OMOs. As the government borrowing programme was large (central and states), the problem was exacerbated. This is where the RBI stepped in and has so far bought back around Rs 3 lakh crore of securities from the banks. Two things stand out here. First, the RBI has actually increased reserve money and hence money supply. While the concept of automatic monetisation of fiscal deficit was abandoned in 1997, the same has been done through the back door where fresh issuances are subscribed by banks and other FIs. At stage 2, the RBI buys back older stock of securities and in return actually earns an income in the form of interest. Assuming a rate of 7.5 per cent on these securities, the RBI earns an additional Rs 22,500 cr of interest on Rs 3 lakh crore. The more fascinating part of this story is that the same additional income which the RBI earns, under ceteris paribus conditions, would add to the surplus of the central bank which will get transferred back to the government which had paid this amount on the securities in the form of the coupon payment. As far as banks are concerned, this is a good move as they extinguish GSecs which give say 7.5 per cent and use it to lend which at the January WALR would be 9.8 per cent yields, a net interest income of 2.3 per cent or Rs 6,900 crore. As most of the lending has been to the retail sector, this would also have low risk. To the extent that corporates get these funds, they would also be better off as tight liquidity would have raised their cost of funds. The dollar swap is also a win-win situation. Banks have with them forex assets of around $18.2 billion, of which $5 billion has been exchanged for cash. The successful programme yielded a premium or implicit forward rate of 3.75 per cent. If we look at it from the point of view of banks, this works well. They get cash for idle dollars being held. They can earn 9.8 per cent on these funds and hence get a net return of a little above 6 per cent. They run the risk of the rupee appreciating instead of depreciating. The 10-year forward rate was 3.6 per cent but could change in the next two years and hence the 3-year cover of 3.75 per cent is of advantage. If the money is lent, they would earn Rs 2,100 crore a year. The alternative would have been to raise CDs or keep rolling over through the repo, which is higher at 6.25 per cent. Therefore, a cost of 3.75 per cent is very low and money can be lent for longer duration. Even if invested in GSecs, the net return would be 3.75 per cent (assuming a return of 7.5 per cent), and banks will be better off. The RBI too is better off because when it adds to its forex kitty, the returns in net terms is around 1.1 per cent. Now the RBI can still earn this 1.1 per cent as its forex reserves increase, but can top it up with the 3.75 per cent gain, which is being paid by banks. Therefore, the RBI is actually earning around 4.85 per cent, which is nearly Rs 1,700 crore. If another round is used, this amount will double as earnings will increase. Again as these are new measures used by the RBI for balancing liquidity, these gains will show up in the surplus of the central bank which gets transferred to the government in the form of non-tax income. Therefore, the entire liquidity balancing operations of the RBI has brought about a truly Pareto optimal solution where all participants – government, RBI, banks and borrowers — are all better off and no one is worse of.