Surplus liquidity in the system: How it came and how it may go
Large doses of liquidity have
been provided by the Reserve Bank of India (RBI) starting in 2020 even before
covid, when it used its LTRO (long term repo operations) and OMO (open market
operations) as tools A complex set of economic
conditions would be needed for India to attain normalcy on this count
When the US Fed
started its quantitative easing (QE) plan, it was to make liquidity available
at a time when every institution was suspicious of the solvency of the other,
as it was unclear how toxic their assets were. To help, the Fed bought other
bonds apart from US treasuries.
India’s QE has been
different. Large doses of liquidity have been provided by the Reserve Bank of
India (RBI) starting in 2020 even before covid, when it used its LTRO (long
term repo operations) and OMO (open market operations) as tools. This was later
topped with TLTRO (targeted long-term repo operations) and its GSAP (government
securities acquisition programme). In its pandemic response, RBI had stated
that it would do everything needed to ensure adequate liquidity in the banking
system. Banks could lend this money at low interest rates, which was the crux.
RBI’s repo rate was lowered, as was the CRR (cash reserve ratio). The Centre
backed this programme by providing a credit guarantee for loans given to micro,
small and medium enterprises (MSMEs), a scheme that was subsequently expanded
to include multiple sectors.
Let’s look at the
consequences. Liquidity evidently increased: Almost ₹6-8 trillion of
surplus liquidity resides in RBI’s reverse repo window (both overnight and
short-term variable rate reverse repo or V3R). This surplus has just been
increasing as RBI kept buying paper from banks to provide liquidity. But
deployment avenues were limited for a variety of reasons.
First, demand was
anaemic, with low capacity utilization rates in most sectors (60-69%) holding
back investment. Second, private investment in infrastructure hasn’t yet taken
off. Third, while MSMEs borrowed on the back of the guarantee, the funds were
used to repay loans and maintain business rather than for growth. Fourth, banks
too were cherry picking customers as they had just about come to get bad loans
off their books. Besides, the backstop’s precondition on loan performance as of
1 March 2020 meant that stressed units did not qualify.
The puzzle was the
success of RBI’s bond acquisition spree through GSAP, as it went about buying
securities from banks. Together with OMO, a total of ₹2.4 trillion has
been released by RBI so far this year with the goal of anchoring yield
expectations. The logic of this was hard to understand because there was little
point in banks giving up securities which paid an annual interest rate of, say
5-7%, depending on their residual tenor, to get cash that was put in the
reverse repo or V3R window for returns of just 3.35-3.75%. These operations led
to a negative carry for banks. It would have made sense if they procured
liquidity to extend loans at 9% or more per annum. One justification was that
the securities were illiquid and banks got a chance to offload these even
though their returns were ultimately negative.
How RBI exits a
surplus scenario of ₹8 trillion is now a challenge. Curbs
on its reverse repo window would spook the system. Raising the reverse repo
rate will be taken as a policy signal of tightening, which would not be in
consonance with its current commentary. GSAP buys have stopped, which is fine,
but it does not address the issue of surplus liquidity.
Banks, on their
part, are trying their best to stop deposits from coming in by keeping interest
rates low. This being so, it’s no surprise that funds are moving to equities
and crypto assets. While this can ensure surpluses don’t increase, it does not
reduce them either.
Ironically,
financial markets have not quite reacted positively to surpluses, as government
bond yields remain high in relative terms, with the 10-year yield in the region
of 6.35%, up from under 6% till 21 January. In fact, there has been a battle
between RBI and bond players, with the latter demanding higher yields (lower
prices). There was a phase of RBI auctions not going through or devolving on
primary dealers. Almost ₹1.5 trillion of
auctions went unsubscribed by the market this year. Therefore, surplus
liquidity has not really reduced interest rates sharply, though it could
counter-intuitively be argued that rates would’ve gone up further, with the
10-year paper crossing 7%, had RBI not acted as it did.
The market has been
wary of high government borrowing and inflation. The Centre’s borrowing
programme is to be retained at around ₹12 trillion for the
year, while inflation is expected to be around 5.5%. The recent supplementary
demand put before Parliament involving ₹3 trillion of cash
payouts does mean higher borrowing at some point of time. Besides, if GST
revenues don’t remain buoyant, the government’s need for additional borrowing
to plug shortfalls in GST-compensation-cess collections would increase.
It does look as if
draining excess liquidity will require a combination of some developments.
First, bank credit demand must pick up, with the economy’s investment cycle
turning around. Second, the Centre should be borrowing more so that banks
automatically channel their surpluses back. Third, RBI should be going in for
some OMO sales to reverse its GSAP effort, so that these securities return to
banks. Until these happen, either thanks to a central bank push or through the
natural course of events, big surpluses will stay.
More importantly,
the relationship between surplus liquidity and interest rates will remain
severed.
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