How much liquidity does RBI want: Appropriate, adequate, or abundant?

Water, water, everywhere,

Nor any drop to drink.

 

These two lines from Samuel Taylor Coleridge’s poem, The Rime of the Ancient Mariner, summed up sailors’ plight: they are dying of thirst despite being in the middle of the ocean since all around them is the undrinkable saltwater.

 

These days, if you sneak into the cabins of senior bankers managing liabilities, you’d find them facing a similar situation, with one difference – in place of water is money. The system is slush with money but the pile of low-cost savings and current accounts is depleting every quarter. There is no cheap money to lend at a decent margin.

 

So don’t be surprised if you hear them murmuring:

 

Money, money, everywhere

But the cost is high

Cheaper fund is history now

Margin dropping, sigh…

 

In the last week of June, some of the large public sector banks disbursed a few thousand crore rupees in loans to a few public sector undertakings. The one-year loans carried interest rate tags between 5.75 per cent and 5.97 per cent. The banks were under pressure to push credit growth as the end of the June quarter approached. But how would they make money if they give loans at such low rates?

 

Liquidity in the system had a deficit of Rs 2.4 trillion towards the end of the last financial year (on March 23); it is now in surplus of around Rs 3 trillion. On July 4, the surplus crossed Rs 4 trillion. This shift is due to aggressive open market operations, or OMOs, by the Reserve Bank of India (RBI).

 

The RBI had bought Rs 4.95 trillion worth of bonds through OMOs, releasing money into the system. In addition to that, there was a buyback of Rs 1.5 trillion worth of bonds by the government, adding to core liquidity in the system.

 

With too much money in the system, overnight rates started dipping below the standing deposit facility, or SDF, the floor of the RBI’s liquidity adjustment facility (LAF) framework. 

 

This prompted the RBI to conduct variable rate reverse repo (V-RRR) auctions to drain excess liquidity from the system and bring the overnight rate within the LAF corridor.

 

For managing short-term liquidity in the banking system, the Indian banking regulator uses the LAF. It’s a ‘corridor’ as against a ‘floor’ architecture that many central banks follow — a range within which the overnight interest rates in the money market are expected to fluctuate.

 

The corridor was as high as 300 basis points (bps) in 2010. Since then, it has been gradually narrowing: first to 200 bps and then eventually to 50 bps (in 2017), where it now stands. One bps is a hundredth of a percentage point.

 

Three policy rates create the corridor: the SDF rate is the floor; the repo rate rests at the middle; and the marginal standing facility (MSF) rate is the ceiling.

 

The SDF rate was introduced as the floor of the LAF corridor in 2022, replacing the fixed rate reverse repo (F-RRR).

 

Currently, the repo rate is 5.5 per cent, SDF 5.25 per cent, and MSF 5.75 per cent.

 

The objective of LAF is to keep the overnight call money rate in the range. The weighted average overnight call rate nowadays is hovering around 5.25 per cent, the floor of the LAF corridor. At times, it falls below that, prompting the RBI to announce V-RRR.

 

The money yo-yo is keeping the banking community perplexed.

 

In the first week of June, the RBI reduced the policy repo rate for the third successive time. The three rate cuts since February — the latest being a 50-bps cut — have brought the repo rate down from 6.5 per cent to 5.5 per cent in four months.

 

On top of that, the action-packed June policy also pared the cash reserve ratio (CRR) by 100 bps to 3 per cent. (CRR is the portion of net demand and time liabilities, a loose proxy for deposits, which commercial banks keep with the RBI, on which they do not earn any interest.) Staggered over four instalments between September 6 and November 26, the CRR cut will release Rs 2.5 trillion into the system.

 

Between January and early June, the RBI had infused Rs 9.5 trillion in liquidity. Now, it is sucking out money from the system.

 

In the second week of July, it announced a seven-day V-RRR auction of Rs 2.5 trillion — the highest ever. Banks put up bids worth Rs 1.5 trillion.

 

V-RRR is one of the ways of draining excess money from the system for the short term. There are other ways, too. One of them is OMO — selling government bonds to suck out liquidity for a longer term. (Of course, OMO can be used for infusing money, too.)

 

The RBI’s intervention in the currency market also has its impact on liquidity. For every dollar it buys, an equivalent amount of local currency is released into the system; when it sells dollars, rupees are sucked out.

 

The RBI has cut the repo rate and the CRR to encourage banks to lend as well as pare the cost of funds for the borrowers. Everybody wants bank credit to grow to bolster growth in the world’s fourth-largest economy. In FY25, the Indian economy grew at 6.5 per cent — its slowest pace since FY21. The RBI has projected similar growth for the current year. 

 

Can an abundance of money and a relatively low interest rate alone trigger credit growth? Or is demand the key to growth?

 

In the current decade, the best phase of credit growth was a three-year period between FY06 and FY08. The credit growth was 25.2 per cent in FY06. It was even stronger the next year — 28.1 per cent — before dropping to 21.6 per cent in FY08. The average expansion of non-food credit during those three years was around 27 per cent.

 

What was the policy rate at that time? The repo rate, which was 6.75 per cent in 2006, rose to 7.75 per cent by the end of the year, and then increased further to 9 per cent by July 2008. This makes it clear that there is no direct correlation between low interest rates and growth in credit. Demand is the key.

 

In recent times, in FY23, India’s bank credit grew by 15 per cent — the highest since FY12.

 

Year-on-year bank credit, until the last week of June, continues to be in single digits — 9.5 per cent, sharply down from 19 per cent in the year-ago period. The deposit growth continues to outpace credit growth.

 

Things could change. In the fortnight ending June 27, credit growth has been the highest in the current financial year. We need to wait and watch if this sets the trend.

 

A recent economic research report of ICICI Bank Ltd says empirical research shows that liquidity has a positive impact on asset markets, with higher liquidity pushing equity prices higher, and corporate bond spreads over government bonds lower. Higher liquidity also results in higher consumption and retail inflation with a lag of three quarters.

 

Meanwhile, retail inflation dropped to 2.1 per cent in June. This makes average FY26 Q1 inflation 2.69 per cent, below the RBI estimate of 2.9 per cent. Analysts see inflation dropping below 2 per cent in July and the Q2 inflation undershooting the RBI estimate. If that happens, there could be another rate cut in October. But that’s a different story.

 

If credit demand does not pick up but banks start pushing for credit growth aggressively, throwing caution to the wind, we may end up seeing cracks in their balance sheets, which acquired resilience after the banking regulator’s clean-up exercise in the last decade. Too much money can also create asset bubbles and impact inflation, which hit its six-year low in June — and may reverse. This is why the RBI doesn’t want the overnight rate to go below the SDF rate.

 

When liquidity is in surplus, the regulator has many ways of draining it. The key question is: how much liquidity does it want in the system? Appropriate, adequate, or abundant? On this will depend whether we will see the creation of asset bubbles and inflation shooting up — or the smooth, hiccup-free return of the growth impulse to the economy.  The writer is an author and senior advisor to Jana Small Finance Bank Ltd. His latest book: Roller Coaster: An Affair with Banking. To read his previous columns, log on to www.bankerstrust.in. X: @TamalBandyo