Why in the News
Liquidity in India’s banking system has dried up, pushing overnight call rates to 5.6-5.7% and the 10-year government bond yield to test 7.5%. The squeeze comes only weeks after a foreign currency deposit scheme drew about $143 billion, and the Reserve Bank of India (RBI) has now begun injecting funds.
What is banking liquidity, and how has the squeeze shown up?
- What it is: Liquidity is the spare cash in the banking system after banks meet their obligations. It works like a household’s cash in hand: when it runs short, borrowing becomes costlier.
- Call money market: Overnight interbank rates were recently below the repo rate, the RBI’s policy rate. Some banks now borrow from the RBI’s emergency Marginal Standing Facility (MSF).
- Bond market spillover: At the week’s auction of Treasury bills (T-bills), short-term government debt, bidders demanded higher cut-off yields, the highest interest accepted. The auction was cancelled.
- The takeaway: A cash shortage among banks quickly becomes higher interest rates in money and bond markets.
Why did a large deposit inflow not ease the shortage?
- The inflow: The scheme drew foreign currency through three channels, and about $133 billion came as deposits:
- Foreign Currency Non-Resident (Bank) (FCNR(B)) deposits, non-residents’ foreign currency accounts in Indian banks;
- overseas foreign currency borrowing;
- external commercial borrowing (ECB), loans raised abroad.
- Peak surplus: After the scheme closed on August 31, the liquidity surplus peaked above ₹10 lakh crore in early September.
- Tax outflows: Advance tax payments, topped by Goods and Services Tax (GST) payments, drained the surplus. After September 20 it fell below ₹5 lakh crore.
- Credit outpacing deposits: Banks lent about ₹15 lakh crore more and invested about ₹5 lakh crore more, so banks’ spare deposits shrank.
- Idle government cash: The government’s cash balance, meaning taxes collected but not yet spent, stood at ₹5-5.5 lakh crore by end-September. Slow spending kept this money out of bank deposits.
How did RBI actions and market events drain cash?
- Open market operation sales: The RBI sold government securities through open market operations (OMOs), first for ₹1 lakh crore and then for ₹25,000 crore. Each sale removes cash from the system.
- Defence of the rupee: Forex reserves fell by $48 billion from their September peak. A stronger dollar cut the value of non-dollar holdings, and RBI dollar sales pulled rupees out of banks.
- Large IPOs: Very large initial public offerings (IPOs) lock up investors’ money until listing, distorting the balance between bank deposits and credit.
- Daily CRR rule: The cash reserve ratio (CRR) is the share of deposits banks must keep with the RBI. Banks must hold 99% of it every day, so they hoard cash.
- Uneven distribution: About ₹1.6 lakh crore sits in the RBI’s Standing Deposit Facility (SDF), where banks park spare cash, a sign that some banks hold surplus cash others lack.
What could ease the squeeze?
- Variable rate repo: The RBI has started Variable Rate Repo (VRR) operations, auctions that lend banks cash for short periods.
- Thumb rule: Ideal liquidity is about 1% of net demand and time liabilities (NDTL), banks’ deposit liabilities. That is around ₹3 lakh crore, and liquidity has fallen short of it.
- Rate-hike signals: Minutes of the Monetary Policy Committee (MPC), the RBI panel that sets the repo rate, suggested more aggressive rate hikes, which unsettled markets.
Challenges
- Cash-flow uncertainty: Banks cannot predict tax and government cash flows, so they hold liquidity instead of lending it.
- Rupee defence versus liquidity: Dollar sales to support the rupee drain cash just when banks need it.
- Fickle deposits: Large IPOs pull savings from bank deposits, making deposit growth unpredictable.
Way Forward
- Faster government spending: Quicker spending would return idle government cash to bank deposits.
- More VRR auctions: The RBI should keep running VRR auctions until the shortage ends.
- Shift in OMOs: The RBI should move from OMO sales to purchases if the squeeze persists.
Conclusion
Record foreign currency inflows have not prevented a cash squeeze. How soon government spending picks up, and whether the RBI keeps selling dollars, will decide when the squeeze eases.
Key numbers
- Incremental deposits from the scheme: About ₹13-14 lakh crore.
- Bank deposits: ₹260 lakh crore before the scheme, ₹278 lakh crore by August-end and ₹283 lakh crore by September-end.
- Forex reserves: $543 billion (June 5), peak of $645 billion (September 11), $597 billion (October 9).
- Bond yields: Spiked to 7.4-7.45%.
Matching Previous Year Question
“[2020] If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do? 1. Cut and optimize the Statutory Liquidity Ratio 2. Increase the Marginal Standing Facility Rate 3. Cut the Bank Rate and Repo Rate Select the correct answer using the code given below: (a) 1 and 2 only (b) 2 only (c) 1 and 3 only (d) 1, 2 and 3 ANSWER: (c)”
