An employee counts Indian five-hundred rupee banknotes at a bank branch. (Photographer: Dhiraj Singh/Bloomberg)

RBI Gets More Flexibility To Mop Up Surge In Liquidity

The Reserve Bank of India (RBI) is expanding the tools at its disposal to suck out the surge of liquidity in the banking sector following the government’s decision to scrap Rs 500 and Rs 1000 notes.

On Friday, the central bank said that the government has raised the limit for issuing market stabilization scheme (MSS) bonds to Rs 6 lakh crore compared to Rs 30,000 crore earlier.

After the withdrawal of the legal tender character of the 500 and 1000 denomination notes with effect from November 9, 2016, there has been a surge in the deposits with the banks. Consequently, there has been a significant increase of liquidity in the banking system which is expected to continue for some time.
RBI Press Release

In a separate release, the RBI said that it would auction cash management bills of Rs 20,000 crore under the market stabilization scheme on Friday.

The funds that can be absorbed via reverse repo operations and through the market stabilization scheme should suffice for now to manage liquidity. This should also allow the cash reserve ratio (CRR) hike to be rolled back gradually.
Lakshmi Iyer, Head Of Fixed Income, Kotak Mutual Fund

On November 26, the RBI, in a surprise move, had asked banks to maintain a 100 percent cash reserve ratio (CRR) on deposits between September 16 and November 11. The decision was intended to suck out close to Rs 3.25 lakh crore from the banking system. The central bank had, however, clarified that the CRR hike was temporary and would be reviewed after the government hikes the limit for issuing bonds under the market stabilization scheme.

This has now been done, suggesting that the RBI may review its CRR hike which would come as a relief to banks.

“This (CRR hike) is a very temporary measure. We have already indicated to banks that the RBI is going to be lenient with banks. In the initial days of the incremental CRR hike; banks will not be penalised if they fall short in complying for a couple of days. Once the government is ready with market stabilisation scheme bonds, the RBI will immediately review the situation,” said RBI Governor Urjit Patel in an exclusive interview to BloombergQuint earlier this week.

The roll-back in CRR, however, may be gradual, said SoumyaJit Niyogi, associate director for credit and market research at India Ratings.

The CRR may be released in a staggered manner rather than in one go based on the evolving liquidity situation.
SoumyaJit Niyogi, Associate Director - Credit and Market Research at India Ratings

Managing Post-Demonetisation Liquidity

Between November 10 and November 27, the banking sector received Rs 8.45 lakh crore in deposits of old notes. The result was a sharp jump in liquidity and banks rushed to park these surplus funds with the RBI through the reverse repo window.

This put the RBI in a peculiar spot since it only had Rs 7 lakh crore in government bonds to give to banks in lieu of their deposits. To overcome a shortage of government bonds, the RBI hiked CRR and has now increased the limit of bonds that can be issued under the market stabilization scheme.

Sucking out liquidity is also important from the perspective of managing the interest rate environment and the currency. Banks had rushed to invest the additional liquity in government bonds, which had pushed the 10-year benchmark yield to below the repo rate of 6.25 percent. This, in turn, narrowed the differential between developed market bonds and Indian bond and led to outflow of capital, which put pressure on the Rupee.

How RBI Manages Liquidity

In a note issued on November 28, CRISIL Research detailed the four key tools available to the RBI to suck out the additional liquidity and the implications of each of these. This includes reverse repo auctions, cash reserve ratio hikes, market stabilization scheme bonds and sales of government bonds through open market operations.

  • Reverse repo auctions: A facility through which banks park their excess funds with the RBI in exchange for equivalent amount of government bonds. Banks earn an interest of 5.75 percent on these deposits.
  • Open market operations (OMO): Sale of government bonds under the OMOs are undertaken to with an objective to adjust liquidity in the market on a ‘durable basis’. By undertaking OMOs, the RBI can influence flow of credit in the economy.
  • Market stabilization scheme (MSS): Under MSS, government bond issuances are undertaken to absorb rupee liquidity. The scheme was first introduced to suck out liquidity created by foreign capital inflows. This can have adverse implications on the government’s borrowing program.
  • Cash reserve ratio (CRR): A hike in CRR permanently absorb liquidity from the system. It is the specified ratio of deposits that the banks have to park with the RBI as reserves. Banks no longer have access to these funds for any commercial activity. The RBI also does not pay any interest on these reserves.