RBI’s Baby Steps On Liquidity Are Achieving Little So Far
The RBI’s VRRR auctions have failed to push up the cost of absorbing liquidity as the surplus has risen, said Deutsche Bank.
The Reserve Bank of India’s early moves to at least normalise the cost of liquidity, if not begin withdrawing it, are falling short. This, as the near Rs 11-lakh-crore liquidity surplus is keeping the cost of liquidity at close to the reverse repo rate, which acts as the floor on interest rates.
While the RBI and its governor Shaktikanta Das have repeatedly assured the market of liquidity support, the central bank has been conducting variable rate reverse repo auctions to ensure that the cost of short-term borrowings does not fall below that floor rate, which is currently at 3.35%.
Over time, the idea is to push up the rate at which liquidity is absorbed via these variable rate reverse repo auctions, which would make it easier for the central bank to eventually raise that benchmark.
The size of the liquidity surplus, however, has drowned out the impact of recently conducted auctions, Kaushik Das, chief India economist at Deutsche Bank, said in a report dated Sept. 7, 2021.
According to the report:
In January 2021, when the RBI had re-started the VRRR auctions, the cut-off rate for the Rs 2-lakh-crore 14-day auction was at 3.54%. At that time, the surplus was around Rs 6.4 lakh crore.
In the last VRRR auction of Rs 3 lakh crore for a 14-day tenor on Aug. 27, the cut-off rate moderated to 3.42%, as the liquidity surplus had increased above Rs 8.5-9.0 lakh crore by end-August. It was higher than the Rs 11 lakh crore including government cash balances.
The recently announced additional VRRR auction of Rs 50,000 crore for a seven-day tenor has seen a cut-off rate of 3.38%, close to the reverse repo rate of 3.35%.
If the action is unlikely to impact market dynamics or provide a monetary policy signal, why announce it then?
According to Kaushik Das, an “ever-cautious“ RBI is testing the market reaction before it announces longer-term liquidity absorption in the October policy.
It is also probably to signal to the market in a subtle manner, that the central bank has likely reached its tolerance limit as far as the upper threshold band of surplus liquidity is concerned.Kaushik Das, Chief India Economist, Deutsche Bank
Moving Beyond Baby Steps
Many think that more decisive action on the huge liquidity surplus and the cost of this liquidity is overdue.
Apart from longer-term VRRR auctions, which would signal a more durable absorption of liquidity, the central bank’s support to the bond markets via G-SAP purchases may no longer be necessary.
According to economists at ICICI Securities Primary Dealership, the RBI may resort to VRRRs in a bigger way and to taper G-SAP purchases in Q3 either completely or partially.
Deutsche Bank, too, sees the size of G-SAP auctions being tapered in the October-December quarter.
More significantly, the Monetary Policy Committee’s forward guidance may also be tweaked to acknowledge growth revival and that could in turn set the stage for phased normalisation of LAF corridor beginning December, said ICICI Securities Primary Dealership’s Economists A. Prasanna and Abhishek Upadhyay.
The October policy offers the MPC and RBI ample time to prepare markets for a move from ultra-accommodation to accommodation.ICICI Securities Primary Dealership
Suyash Choudhary, head of fixed income at IDFC Asset Management, shared a similar view.
Speaking to BloombergQuint, Choudhary said the question on the market’s mind is where the central bank goes from here. Will the central bank simply use VRRR as a tool or consider options such as issuing bonds under the market stablisation scheme?
The other question is whether the 3.35% reverse repo rate is overstaying its welcome in some sense, Choudhary said. “Remember a bank is raising money at 3.85-3.90% for one year today. Housing finance and non-bank finance companies are raising at 4.25-4.30%. Now, whether that amount of accommodation for such balance sheets is required or not is something that one can always argue on,” said Choudhary.
MPC member JR Varma had argued that it was time to raise the reverse repo rate at the August meet of the panel, citing the need to maintain the credibility of the inflation targeting framework.
“In my view, a phased normalisation of the corridor would increase the ability of the MPC to keep the repo rate at 4% for a longer period, and this should in my view be a greater priority for the MPC than maintaining an ultralow reverse repo rate for some more time,” Varma had said.
The liquidity surplus in the system is so large that it will take time for it to get drained out naturally via the currency creation process, Neeraj Gambhir, treasurer at Axis Bank had said in an interview after the August monetary policy review. However, the central bank may not wait for that to happen before it starts normalising the overnight rates, he said. "The sequencing may need to be different."