OMO is not the right tool to address liquidity
RBI buying government bonds through OMO (Open Market Operations) looks more like deficit financing than liquidity easing. The central bank will buy Rs 10,000 crores of government bonds through purchase auctions on the 24th of November 2011 and in all likelihood will announce more of Rs 10,000 purchase auctions in the coming weeks. Every purchase auction will be followed by a government bond auction of Rs 13,000 crores as the government borrows to finance its rising fiscal deficit. The back to back purchase auction and government bond auction raises eyebrows on whether the RBI is being forced to finance the government in the guise of liquidity easing measures.
Liquidity will have to be eased by at least Rs 60,000 crores to bring the system liquidity within the comfort zone of the RBI, which at 1% of NDTL (Net Demand and Time Liabilities) works out to around Rs 55,000 crores. The market at present is borrowing over Rs 125,000 crores from the RBI on a daily basis and in order to bring down this borrowing the RBI will have to buy government bonds for around Rs 60,000 crores in the coming weeks. To place this in perspective, RBI by buying government bonds for Rs 60,000 crores will be financing around 15% of the government borrowing for this fiscal.
The RBI has stated that it will not use CRR (Cash Reserve Ratio) to infuse liquidity into the system as it is seen as a monetary signal rather than a liquidity tool. A 1% cut in CRR will add around Rs 55,000 crores into the system thereby easing the liquidity pressure.
The question to ask is, is implied deficit financing better than implied monetary easing measure? The answer is no. Implied deficit financing sends out completely wrong signals to the markets. The first signal is that the market will perceive that the RBI is carrying out quantative easing measures, which is negative for both inflation and the currency. Inflation is trending at 9.7% levels, the fifth consecutive month of over 9% inflation while the Indian Rupee (INR) has fallen by over 15% against the US Dollar (USD) over the last three months.
The second signal is that the government, when it finds a captive buyer of its bonds in the form of the central bank will not act to reduce it fiscal deficit. The government is likely to overshoot its deficit by at least 1% this fiscal and recent comments by the Finance Minister of going easy on reducing the deficit is not at all comforting. At a time when markets are plundering bonds and currencies of high debt countries, a rise in level of fiscal deficit is extremely dangerous for the country.
The RBI has been highlighting the fiscal profligacy of the government in all its policy statements. Sounding a warning on deficit and then supporting the deficit by buying bonds is contradictory.
On the other hand a CRR cut, even if taken by the market as a monetary easing measure, will not result in a sharp fall in interest rates in the economy. Liquidity will ease but it will only bring down liquidity from highly negative to manageable levels. Government borrowing will continue as usual and markets will look at the government’s effort to contain its fiscal deficit before taking down bond yields. Government bond yields at stickily higher levels (at multi year highs) due to poor government finances will not bring down lending rates and the RBI will not have to worry about credit growing at a faster pace due to a cut in CRR.
The RBI should also look at other means of easing system liquidity if it does not want to use CRR. In the absence of CRR, buying government bonds to ease liquidity is harmful to the economy.