RBI OMOs unlikely to cause inflation

Because of aggressive bond purchases by the Reserve Bank of India (RBI), banking sector liquidity turned surplus in mid-July, having suffered record liquidity shortage earlier in February-March.

The system liquidity was again drying up fast in October but the central bank quickly stepped in to buy bonds from banks.

Average liquidity surplus in October shrunk to Rs 4,703 crore compared to a surplus of Rs 39,112 crore in September, noted Kotak Mahindra Bank in a research report.

Meanwhile, banking sector credit growth continues to remain tepid and in the single digits as companies stayed away from incurring further capital expenditure at a time when 30 per cent of their installed capacity remained unutilised.

Technically, then, in the absence of robust credit growth, banks should not have any liquidity crisis and RBI should not be doing open market operations (OMOs), or secondary market bond purchases to help banks.

But, the fact is that RBI had to buy a lot of bonds from the secondary market - Rs 2.1 lakh crore in the past 12 months, to help banks come in a neutral liquidity zone now.

But, will this be inflationary? Unlikely, say analysts.

"We expect limited inflation impact, due to a low-money multiplier (four-year low), and ample spare capacity in the economy," wrote Credit Suisse in a research report. Money multiplier is the money (base money) needed to create more money. Unless a bank lends money, it can't create more money. Since banks have slowed their lending exercise, enough money is not getting created and therefore, the multiplier has slumped to a multi-year low. This gap in money creation has led to liquidity shortage, prompting RBI to step in with bond purchase support.

"Inflation can happen only when you are doing more OMOs than necessary. What the central bank has been doing is meeting the needs of the economy, which is not inflationary," said Soumyajit Niyogi, associate director at India Ratings and Research.

Liquidity in the banking system has again become tight because of a number of reasons. Apart from the weak money multiplier, currency in circulation has risen among the public because of festive demand. Holding cash means taking money away from banks and this contributes to the liquidity shortage. According to Credit Suisse estimates, the currency in circulation increased by Rs 2.6 lakh crore over the past 12 months.

"This is just normalising from low levels as percentage of GDP, but necessitates more base money injection. India's high proportion of currency usage needs to fall over time," Credit Suisse wrote in its report.

The increase in currency in circulation is almost same as what the RBI bought in bonds from banks in the secondary market, plugging the leakage. Therefore, this should not be inflationary, say analysts.

However, RBI will have to continue doing OMOs as the currency in circulation is expected to show higher growth in October to December. Besides, banks are already in the process of honouring maturity of $25 billion worth of FCNR (B) deposits that they raised three years ago. This will lead to rupee liquidity drying up, and will have only some marginal impact on exchange rate as RBI has taken responsibility for paying the dollars.

But, to support rupee liquidity needs, RBI will continue to conduct more OMO purchases, without pushing up inflation.