MPC Meet: Moving From Overindulgence To Indulgence
As we head towards the October review of monetary policy, there is some good news and some not-so-good news.
Inflation, which was running above the central bank's target band has moderated and stabilised, albeit at elevated levels. That's the good news. On the other hand, there is unprecedented levels of liquidity in the banking system and concerns around the potential ill-effects of this are rising. That's the not so good news.
It is these two issues, alongside a judgement of whether risks to growth has abated, which form the backdrop of the upcoming monetary policy review.
Liquidity, Liquidity Everywhere...
Before we speak of what can and should be done, let's first understand the nature of this liquidity. The current liquidity in the system is around 7% of net demand and time liabilities, or broadly, banking system deposits.
This liquidity can be attributed to two components — “discretionary” policy operations and other “autonomous” factors. Autonomous factors typically include currency leakages, changes in foreign exchange assets, and volume of government deposits. On the other hand, discretionary liquidity, arises out of the central bank’s operations, including open market operation bond purchases, change in reserve requirements etc.
Amid the pandemic, it was necessary for the RBI to infuse liquidity into the banking system to prevent markets from freezing and to revive market activity and restore investor confidence. More importantly, to ensure adequate flows to sensitive sectors that were liquidity constrained, the RBI needed to incentivise banks, which it did through innovative tools like targeted long term repo operations.
All this added "discretionary" liquidity.
Meanwhile, in contrast to conventional wisdom that global crises causes outflows from emerging markets, the post-Covid period was characterised by massive inflows into emerging economies. This was largely due to liquidity created by central banks in developed countries (who are exporters of capital) coupled with massive counter-cyclical fiscal spending. Atop this, India saw a sharp turn in trade balance from a deficit to a surplus amid the crisis.
As the RBI intervened to prevent a knee-jerk appreciation in the rupee, liquidity was added.
Put together, this meant that the RBI's efforts to pump liquidity into the system were further augmented by the improvement in the country's balance of payments position.
There was also an important change in objective behind the RBI's intervention in markets.
Conventionally, bond purchases are done with an objective to create liquidity in the financial system in sync with requirement of the economy. A byproduct of such an operation is softening of bond yields due to buying of bonds by central banks.
This time around, the causation has changed. The central bank's principle objective is to keep bond yields at desired levels by buying sovereign bonds, while liquidity creation is its byproduct.
The Rs 12-Lakh-Crore Question
The question now is how to tackle this record level of liquidity.
First, we have to accept that taking a call on the duration or potential impact of future Covid wave is extremely difficult. Waiting for a clear signal on that, however, could become costly. We may have to live with the virus for a long time and the pandemic could slowly become an endemic.
Therefore, it is better to take pre-emptive measures to moderate the surplus, much before tightening starts. Think of it as removing the excess fat from the body before it becomes toxic.
At present, the RBI is taking comfort in the fact that credit offtake is low as corporates are reducing leverage. We are nowhere close to overheating. But that does not ensure that these risks won't emerge in the future.
Equally, this unprecedented level of system liquidity amid muted demand for credit could distort risk assessment and market pricing of products. Cheap short-term rates also amplify abnormal demand in other financial market segments. A prime example of this is the IPO funding market.
What can RBI do to address these conundrums?
Since the MPC is empowered to take decision on the monetary policy stance and the repo rate, it is likely to stay in cruise mode for some time.
The Menu Of Options
There are broadly two options on the RBI's menu right now—restrict the supply of money; push up the cost of money; or do both.
To mop up the durable liquidity in a sustained manner, RBI can issue bonds under Market Stabilisation Scheme (MSS). However, it is unclear whether that tool can be used now since the central bank has also been given the option to activate a standing deposit facility where surplus liquidity can be absorbed at rates below the reverse repo rate. The RBI is yet to use this window and a key complicating factor here is the rate at which this window will absorb liquidity.
More importantly, the impact of any MSS bond issuance on benchmark yields will be severe.
If these options are ruled out, then the RBI can stop buying bonds under the G-SAP scheme to restrict the supply of money. But the central bank may think twice before doing that as these purchases provide comfort to the market and prevent long-term interest rates from rising.
The other option is for the RBI to sterilise liquidity on a regular basis and push up short-term rates in a staggered manner. To do this, it can use longer-term variable rate reverse repo auctions of of 30-56 days tenor. This will lock in the system liquidity, even as the longer tenor will push very short-term rates towards the repo rate of 4%.
Tactically, the RBI could consider very long-term variable rate reverse repo auctions of 9-12 months. However, if banks expect rates to rise over this period, they may not be keen to lock-in funds for such a long period. This could be addressed by allowing a reversal of that transaction.
A complementary action would be to start normalising the corridor between the repo and reverse repo corridors back towards 25 basis points in baby steps. This is currently at 65 basis points.
The interest rate corridor was expanded during the crisis, and if we believe that economic uncertainty has eased, it is judicious to wind back measures which are akin to firefighting.
Watch The Signals
Each or any of these moves by the RBI could run into a "signal extraction" problem, i.e., the central bank may see it as normalisation while the market may see it as tightening. The RBI can alleviate this issue with forward guidance which promises an accommodative monetary policy stance till the recovery is firmly entrenched.
The crisis has taught us that central banks need to be flexible. This, however, holds true both during the crisis and in the post-crisis phase.
Restoring normalcy is a challenge but it is key. Else, market participants develop an unhealthy dependence on the central bank and demand extended flexibility or support. This, in turn, could create unrealistic expectations from the central bank and impair its credibility.
Soumyajit Niyogi is Associate Director at India Ratings & Research – A Fitch Group Company. Views expressed here are his own and do not reflect those of the organisation.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.