The Reserve Bank of India’s liquidity stance has not convinced several experts, including even a member of the Monetary Policy Committee. What the RBI does with liquidity, and why it affects the market. ET explains:
What is RBI’s approach to liquidity management?
The central bank follows a ‘corridor’ liquidity management system – with a ceiling and a floor rate – where the repo rate – the rate at which the RBI injects liquidity – is the policy rate that acts as the ceiling for the corridor, while the reverse repo rate acts as the floor of the corridor. The ideal situation is one where call rates move within this corridor, which the central bank ensures through its liquidity adjustment facility (LAF). The operational framework of monetary policy aims to align the weighted average call rate (WACR) with the policy repo rate through proactive liquidity management to facilitate transmission of repo rate changes throughout the financial system.
How does this work?
Banks try to borrow their lack of reserves from the interbank market. If reserve requirements like cash reserve ratio and statutory liquidity ratio cannot be met in the interbank market, then banks borrow funds from the RBI under LAF. If banks are net borrowers under LAF, it can be said that systemic liquidity is in deficit. Conversely, if banks deposit more than the reserve requirement, then it becomes a net lender to RBI, and systemic liquidity can be said to be in surplus.
What are the main drivers of liquidity?
The three main drivers of liquidity are the money balances of the government with RBI, changes in currency in circulation in the system, and the forex operations of the central bank. RBI’s market operations or cash reserve ratio changes apart from the monetary policy stance (through its liquidity operations) also tend to affect liquidity level in the system.
What has caused a recent strain in liquidity in the system?
When Covid-19 hit the economy in 2020-21, RBI ensured that there was ample liquidity to support businesses affected by the pandemic besides adopting an accommodative policy stance that led to excess liquidity in the system. But, over the past two years, several factors have led to tight liquidity conditions. This included a withdrawal of accommodative stance resulting in a smaller infusion of liquidity. Also, credit growth outpaced deposit growth, causing fund constraints while government spending also slowed. After the outbreak of the Ukraine war, India’s forex reserves shrank too much, affecting the liquidity of the rupee as the RBI had to sell dollars to stabilize the rupee. Reserves have started improving over the past six months with last year’s withdrawal of Rs 2,000 notes also having an effect.How did RBI react?
Over the past two months, the central bank has fine-tuned its liquidity operations to mitigate the liquidity deficit. On an average, the RBI injected liquidity for 1.6 lakh crore.
Did it help?
Although liquidity has eased, the call money is still trending marginally above the repo rate. Goldman Sachs in a report suggested measures such as long-term repo operations when government cash balances build and spreading government borrowing to ease cash holdings besides encouraging banks to increase dependence on the interbank market rather than the RBI for day-to-day liquidity needs.
(tagsTo Translate) Reserve Bank of India