RBI will have to think out of the box on liquidity
RBI will have to think out of the box to ease an expected liquidity tightening situation. Banking system liquidity is expected to worsen going forward on the back of a rising trade deficit, muted capital flows and a weakening rupee. The second half of the fiscal year is also the busy season due to harvests and festivals. Credit demand will pick up and banks starved of liquidity will have to raise rates to borrowers to fund credit. Banks will have to borrow heavily from the RBI in the repo window to maintain daily liquidity requirements.
Banks borrowed Rs 70,000 crores on a daily average basis last week, up from Rs 17,000 crores seen in the week before last. Advance tax outflows of over Rs 45,000 crores impacted liquidity but given that the government is maintaining an overdraft with the RBI of around Rs 28,600 crores, the advance tax will go towards paying off the overdraft rather coming back into the system. Maturity of cash management bills worth Rs 14,000 crores will come back into the system but this will not be enough to ease pressure on liquidity.
The sharp jump in trade deficit in the April-July 2011 period is liquidity negative. Trade deficit stood at USD 54.9 billion in the April-July period against USD 47.8 billion in the same period last year, a year on year rise of almost 15%. A rise in trade deficit leads to an outgo of USD from the system. If the trade deficit is not bridged by capital flows from abroad it leads to a negative impact on the Indian Rupee (INR). Capital flows this year are down sharply from last year with net FII purchase of equity and debt for the January- August 2011 at Rs 18,000 crores against Rs 102,000 crores seen last year. The INR has depreciated by 8% against the USD in the last month and a half on the back of rising trade deficit, weak capital flows and global risk aversion. Worries on Greece defaulting on debt and downgrade of credit rating of Portugal and Italy has led to investors selling emerging market currencies including the INR.
The RBI last year faced a liquidity crunch with banks accessing the repo window for funds for amounts of over Rs 140,000 crores on a daily basis. The crunch was largely due to the government maintaining a surplus balance with the RBI of amounts of over Rs 70,000 crores. The RBI in order to ease liquidity embarked on a government bond purchase program of Rs 65,000 crores in the November 2010 to January 2011 period. The bond purchase added primary liquidity in the system but did little to inflation, which was on an upward trend. Inflation as measured by the WPI (Wholesale Price Inflation) was trending at around 8% levels in December 2010 after which it picked up pace to trend at over 9% levels.
The RBI will have to do serious liquidity management this year. If liquidity tightens sharply and banks are forced to come to the RBI for funds, RBI will have to use tools to ease liquidity. Bond purchase is not a solution as it adds to inflation expectations and RBI has been raising rates consistently for the last thirteen months to quell inflation expectations. Inflation printed at 9.78% for the month of August prompting RBI to raise rates in its September policy review.
The RBI can use the LAF (Liquidity Adjustment Facility) window for easing liquidity rather than resorting inflationary tools of bond purchases. If liquidity tightens considerably, RBI can lend longer term funds under repo to ease liquidity. RBI can also allow banks to borrow under the MSF (Marginal Standing Facility) for longer periods of time. Cost of borrowing in the system will go up but it will act as a quasi rate hike and RBI need not raise rates further to bring down inflation expectations. A CRR (Cash Reserve Ratio) cut is also an option as there is scope to bring down CRR from 6% levels. A 1% cut of CRR will add Rs 50,000 crores into the system.
Anything but bond buybacks!