Illiquidity by design

January 29, 2016
A private money trader counts Indian Rupee currency notes at a shop in Mumbai August 1, 2013. India's central bank intervened in the foreign exchange market on Thursday to stop the rupee's slide toward a record low as its defence of the currency, built around draining cash from money markets, came under rising pressure.  REUTERS/Vivek Prakash (INDIA - Tags: BUSINESS) - RTX126TL

A private money trader counts rupee notes at a shop in Mumbai August 1, 2013. REUTERS/Vivek Prakash/Files

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What’s making tight liquidity conditions linger? This is one of the most frequently asked questions in India’s economic circles these days, and for good reason. The daily borrowing from the RBI has shot up to $20 billion in January from $12 billion a quarter ago. The interbank call money rate is trending a notch higher than the repo rate and different money market rates have tightened since the start of 2016.

Several factors are at play. First, India has experienced its share of foreign outflows over the last few months (as have its peers) and the RBI has been selling dollars, sucking out rupee liquidity. Second, the government has a cash surplus of around $15 billion, up from $8 billion a quarter (and a year) ago. Some of it is a reflection of higher borrowing by states. Taken together, they broadly explain the current liquidity tightness.

Is there a way out? The answer requires a quick look at the RBI’s balance sheet. When deciding its policy stance, the RBI begins with a forecast of nominal GDP growth to ascertain what amount of permanent liquidity is needed. From the asset side of its balance sheet, the RBI can then either buy foreign exchange assets or domestic bonds. Through much of 2015, thanks to healthy foreign inflows, the RBI was able to use the foreign exchange channel. And it worked out pretty well. The RBI grossed record foreign exchange reserves, strengthening India’s visibility on the macro stability radar.

But now global volatility and risk aversion may mean that foreign inflows remain at low levels, causing a drag on liquidity at home. But this does not warrant panic. All the RBI needs to do is switch to the other weapon in its arsenal – open market operations (OMOs). By buying domestic bonds, it can inject much-needed rupee liquidity. Of course, every weapon has its shortcomings. If the RBI does not want to ‘monetise debt’ too much, it can choose to cut the cash reserve ratio of banks. But before the central bank goes that far, even some spending by the government could bring short-term relief.

But if it is all so easy, why isn’t the RBI moving more swiftly? We think it’s a calculated stance. Consider this. Back in the taper tantrum months of 2013, the RBI saw a dramatic fall in the value of the rupee, an experience it is not likely to forget in a hurry. In the current atmosphere of global volatility, it has preferred to keep rupee liquidity tight in order to maintain the currency’s value. And that’s understandable, given how close the rupee was to touching the psychological level of 70 against the dollar.

So, when will the tight liquidity situation ease? We think, as global markets calm down, the RBI may shift its focus from the exchange rate to market interest rates. For a start, it could jack up its repo and OMO interventions, given that the RBI has done just about enough OMOs to reverse its previous stance.

Remember, it all starts with the RBI’s nominal GDP growth forecast. It may be a day early here or a day late there, but the RBI will eventually inject the liquidity that is warranted.

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