Record reserves

Liquidity and bank lending will need careful management

India’s foreign-exchange (forex) reserves increased by $44.9 billion in the week ended September 4. This was the biggest ever weekly increase in reserves, taking them to a record high of $785.7 billion, the fourth-largest in the world. Forex reserves have increased by over $100 billion since June 5, when the concessional swap scheme, including for the foreign currency non-resident (bank) — or FCNR (B) — deposits, was announced. Fund flows under the FCNR (B) window were better than expected at $127 billion. This will help the Reserve Bank of India (RBI) manage the external financial position, where the conditions became challenging, partly because of the Iran war. The level of flows also signals that India can mobilise a significant amount of foreign funds in a relatively short period of time. This would give enormous comfort to both policymakers and the financial market.

 

However, as has been highlighted in this space and elsewhere, this is not a long-term solution for India. It needs long-term non-debt flows to supplement domestic savings. And, the level of inflows in a relatively short period of time has created other complications. The inflows have flooded the banking system with enormous liquidity, which the RBI is finding difficult to absorb. The central bank has done variable rate reverse-repo auctions, but it has not helped much. On Friday, the RBI announced it would sell government bonds worth ~1 trillion in three tranches this month. Theoretically, it should not be very difficult for a central bank to mop up liquidity from the system. It can always sell bonds that it holds to drain liquidity. However, as one commentator noted on this page recently, anything the RBI does in the present situation will have a cost. The announcement of bond sales, for instance, immediately resulted in a selloff in the bond market, with yields on the 10-year government paper going above 7 per cent.

 

However, the RBI will have to use one or a combination of instruments like bond sales, an increase in the cash reserve ratio, or selling bonds under the market stabilisation scheme (MSS). For the MSS, it needs to convince the government to issue such securities and bear the interest cost. It is not clear whether the government is willing to do so at this point. The RBI, however, will have to act quickly. It is worth noting that the weighted average call rate, or WACR — the operating target of monetary policy — last week slipped below the standing deposit facility rate, which is the floor of the liquidity adjustment facility. Given that the WACR on average was around 5.3 per cent between the June and August meetings of the Monetary Policy Committee, the decline effectively means monetary easing of around 25 basis points. However, given the inflation projections, the RBI should be preparing the market for policy tightening. Thus, excess liquidity seems to have created a policy disconnect and needs to be addressed quickly.

 

The other potential risk is the way banks handle this sudden increase in deposits. The chief executive of one of the largest private-sector banks has noted that it could lead to abnormal lending. Bank credit is growing at a healthy pace, and the gross domestic product data for the first quarter showed that investment is picking up. Thus, this is a good time for banks to have increased room for lending. However, the availability of funds and pressure to deploy it should not compromise lending standards. Banks have done a great deal to strengthen their balance sheets over the past decade, and this strength is worth preserving. The regulator needs to maintain close oversight.