Banking system liquidity on the slide due to advance tax outflow

The banking system liquidity has fallen substantially in recent weeks, but experts say that is largely because of advanced tax outflow and is not sudden activism on the part of the central bank even as it might have carefully started to drain the system without flustering the bond markets. 

As of Monday, the banking system liquidity was at a surplus of Rs 4.95 trillion, as against Rs 6.13 trillion a week earlier, on the eve of the deadline for the third instalment of advance tax. In both cases, however, the overall system liquidity was Rs 8.22 trillion. The overall system liquidity takes into account the banking system liquidity plus the government cash balances with the RBI.

The liquidity overhang had figured in the discussions of the monetary policy committee (MPC), the minutes showed. The MPC discussed how huge liquidity could generalise the inflation in the coming days, and how the low interest rates could be benefiting only a few "oligopolistic" firms.  

Reserve Bank of India (RBI) Governor Shaktikanta Das, though, was in no mood to dry up the system just as yet. “A premature rollback of the monetary and liquidity policies of the RBI would be detrimental to the nascent recovery and growth," he said in the monetary policy meetings, the minutes showed. But the latest numbers show that the removal process could be already underway in a silent, non-disruptive manner.  

Even as the system liquidity is remaining intact, there are adjustments being made. The liquidity, it seems, is moving from the banking system to the government in the form of advanced tax. The government, on the other hand, is increasing its balance with the RBI. But the exact balance is not spelt out by the RBI. So, the market immediately doesn’t get to know if some of the liquidity withdrawal is permanent, unless it compares the numbers over a longer time horizon, usually a month or so.   

"The net durable liquidity surplus continues to remain high at around Rs 8 trillion. However, the overall banking system liquidity surplus has fallen temporarily due to advance tax outflow. Once the government starts spending, it should correct," said B Prasanna, group executive and head of global markets at ICICI Bank, adding that the fall was indicative of a build-up of government balances. 

A similar sentiment was echoed by Ashhish Vaidya, head of treasury at DBS Bank. The fall in the numbers could be "due to advanced tax etc and should come back by month-end”. He said there was not much of a sign of a meaningful withdrawal of liquidity. 

But a person familiar with RBI workings said the central bank has indeed slowly started withdrawing its accommodation without trying to give an impression it was doing so.  

A primary way it was draining the system of liquidity is by replacing the old long-term repo operations (LTRO) and targeted LTRO (TLTRO) money with the new and much cheaper on-tap TLTRO, which has some conditionality attached. The on-tap TLTRO announced in September had no takers initially as the segments to deploy the money were pretty narrow. However, in November, the central bank expanded the scope of on-tap TLTRO to 26 sectors identified by the Kamath committee, which is virtually all the segments in the economy.  

After that compensation, the demand for on-tap TLTRO has increased substantially.  

“Liquidity has reduced, most likely due to the early unwind of LTROs, that the RBI had permitted. LTROs that were taken by banks in February and March were at a higher rate, as they were contracted prior to the March rate cuts. Banks, now, are able to access liquidity at a much cheaper rate, and hence, a large amount of these high-cost LTROs were unwound," said Badrish Kulhalli, fund manager at HDFC Life Insurance.  

One point to keep in mind here is that when the original LTRO and TLTRO money came, the banks took that and lent to the highest rated firms, defeating the very purpose of the accommodative liquidity window. Since that was easy money, it sloshed around in the system as it was used for buying short-term bonds maturing in a month or three at very cheap rate. The banks here simply enjoyed rate arbitrage.  

With the much-improved mechanism of on-tap TLTRO, the money is now invested in the companies that are in real need of liquidity and for a longer period. Hence, it is difficult to use the money for speculative purposes. 

“The replacement of LTRO and TLTRO with on-tap TLTRO itself was a tightening of liquidity conditions. There was no taker for that initially, but now the effect will be visible,” said a RBI watcher. Going forward, the central bank might want to tighten the daily maintenance of the CRR from 80 per cent to 90 per cent much before June.  

“Most of the liquidity is because of the RBI’s intervention in the spot currency markets. Near the end of the borrowing programme in February, expect a substantial slowdown in forex intervention. The equities flows are expected to thin by early next financial year, also eliminating the need for intervention,” said the person.  

Crude oil prices are on the rise, and a stronger rupee helps fight imported inflation, but for that demand has to be robust, which is not the case just as yet, said the person.  

The preparations for gradual tightening have to be done much before, and the liquidity may not remain as plentiful as it was during the lockdown period. Unless, of course, there is a renewed surge of the pandemic. 

For now, the relatively lower amount of liquidity surplus “opens up room for the RBI to conduct more open market operations (OMO – through which RBI buys bonds from the market) to support the bond markets," said Kulhalli.  

Sensing somewhat tighter liquidity, the bond yields have started inching up, though the 10-year yields, at 5.91 per cent, are still below 6 per cent. The 91-day treasury bill yields, which had fallen below 3 per cent, has now climbed up to 3.11 per cent in recent days.