RBI is Holding a Tiger by the Tail

GEI welcomes  Sunil Chandra as a new contributor.  His bio follows the article. 

Having earned well deserved global accolades for its deft handling of the 2008-09 financial crisis, the Reserve Bank of India embarked upon a new journey in January 2010 when it started the current cycle of interest rate tightening. By that time, the country had recovered completely from the trauma that a worldwide recession had induced. In fact, with the GDP growth rate having crossed 8%  again and the stock exchanges starting to boom, we all felt that the country was about to cross into the realms of a fairy tale. 

Alas, inflation which had gone into negative territory in mid-2009, was again rearing its ugly head in late 2009 and the Reserve Bank felt it imperative to make its presence felt by initiating the first classic step to reduce the pressure on prices. Cash Reserve Ratio (CRR) was increased by 75 basis points (50+25) in February 2010. However, repo and reverse repo rates were left unchanged. This appeared to be somewhat strange as the excess system liquidity being absorbed by RBI every day through Repo auctions at time was just around Rs 700 billion, a figure that can hardly be described as a liquidity glut for a fast growing economy. Many observers were also surprised that RBI did not chose to increase the reverse repo rates instead which than stood at a historical low of 3.25%.

Baby Steps with Repo and Reverse Repo

Come March and the central bank increased the repo and reverse repo rates effective 19 March 2010 by a mere 25 bps each. Given that the inflation rates had nearly crossed into double digits (9.90%) by then, this appeared to be a baby step. Once again, on 20 April 2010, RBI increased both repo and reverse repo by another 25 bps (to 5.25% and 3.75% respectively) even though these were very low rates by Indian standards. In a system having free floating liquidity exceeding Rs 500 billion, a low return of 3.75% was hardly enough to make banks to go slow on asset purchases and increase loan rates. And yes, another CRR hike of 25 bps was also announced. By this time, the CRR hikes totaling 100 bps had effectively removed roughly Rs 450 billion from the banking system.

Giant Steps with CCR

The RBI has continued to increase repo and reverse repo rates every second month in its battle against inflation which has actually started tapering off. However, it is the CRR hikes that have been the source of a lot of misgivings in financial circles. When RBI increased the rates in the earlier part of the year, it did not factor in a slower growth rate of deposits which stands at 15% YoY as against 18.4% in the previous year. It also did not account for the auction of 3G spectrum which took away over Rs 1100 billion of liquidity from banking system into government coffers. Further, it did not consider a higher than budgeted growth in tax revenues and lastly it looked on helplessly as a rich Government preferred to keep overflowing coffers and did not increase its spending significantly or else even reduce the scheduled borrowing. All these factors combined to suck out precious money and the system became negative in early June 2010.  This then was the cue for RBI to release the banks’ own money that had earlier been impounded in the CRR hikes. But it did not happen.  

The banks began to borrow from RBI small amounts of about Rs 50 to 60 billion in June which increased to Rs 500 billion in September to Rs 800 billion in October and finally peaked at 1720 billion in December 2010.                                                          

Negative Liquidity as Policy

In the meantime, RBI steadfastly refused to even consider decreasing CRR and even stated in its October policy that the negative system liquidity was consistent with RBI’s monetary stance. As the liquidity situation deteriorated, the Bank introduced twice a day repo auctions and allowed commercial banks to maintain lower SLR (government securities holding) at 24% instead of 25%. At the end of November ‘10 a squeezed out system led RBI to allow banks higher access to repo funds and further allowed them to temporarily maintain SLR at 23% instead of the stipulated 25%. Still no cut in CRR was offered.  As the situation did not improve, RBI entered the market through open market operations to buy GOI securities. But the seemingly straightforward CRR cut was not announced.  And then came the mid –mid policy review of December 16, 2010.

Quantitative Easing India Style

In a strange series of steps, RBI decided to introduce liquidity by reducing SLR permanently by 1% to 24%. This would reduce banks’ investments in GOI securities by roughly Rs 480 billion. But who would buy the securities?  After all, almost all banks would turn into net sellers as a result of this step.  Therefore, in a first step of its kind, RBI also simultaneously offered to buy Rs 480 billion worth of securities from banks through a number of weekly OMOs.

Thus, we are now witnessing the very odd situations described in the following.  Every Wednesday, the central bank announces and buys GOI from banks for Rs.120 billion; every other Friday the same Central Bank also helps the Government to place fresh securities with the same banks despite the overflowing coffers; every day the same central bank lends Rs 1500 billion in repos to beleaguered banks to help tide over liquidity shortage; and the same central bank also continues to hold over Rs 2800 billion of Cash Reserves impounded from these very banks including 450 billion taken over during 2010 itself. Thus, the government is selling securities to banks which are selling these securities to RBI whose stock must be reaching historical proportions.  

It is becoming increasingly difficult for observers to understand the very unusual equilibrium which the central bank has imposed upon itself and upon the Indian banking system. The reasons for avoiding a cut in CRR while giving an unworkable cut in SLR are also difficult to fathom. It would appear that the RBI ( by initially reducing liquidity sharply) appears to have caught the proverbial tiger by the tail and is now finding it difficult to let go and is , hence, now being pulled around by the ferocious tiger. One may advocate the RBI to opt for a safer landing by reducing CRR and give immediate relief to the banking system and also prod the government to spend more and allow the banking deposits grow at a healthier pace.

Quantitative easing is an experiment that the U.S. has undertaken.  Their success will not be determined for some time.  But why should India embark on such a parallel experiment when more traditional banking strategies appear to be appropriate?  India has a disadvantage not shared with by the U.S.:  The dollar is the world reserve currency and the rupee is not.

Related Article

Currency Manipulation by Asian Central Banks  by Ajay Shah

8 replies on “RBI is Holding a Tiger by the Tail”

  1. Sir,
    Very nicely analysed and substantiated…. Seeing this view of RBI, when can we expect a situation of normalcy coming back in the system??…

  2. Anuj– since the problem has occurred due to RBI’s direct actions, the solution would have to come from RBI only. However, the liquidity situation itself may now ease as Indian banks have started increasing interest rates and money would shift from other asset classes to bank deposits. Similarly, government spending is also likely to shoot up very soon. The Finance Minister has hinted that much in an interview today.
    But that would still not address the lopsided flow of funds that has been outlined in the article. For that, the Reserve Bank would need to let go , very discreetly, the tail of the tiger it is holding on to, quite needlessly in my opinion.

  3. Sunil,
    Why would a CB hoard local currency, and why is it seemingly allowed to do so?

    ps: your article doesn’t say what RBI’s reserve drain mechanism is, so it’s hard to decipher what their actual position is, or what their intention might be

  4. Roger,
    Reserve Bank’s intention was to squeeze liquidity out of the system so to make loans costlier in order to battle inflation. In India, we still use Cash Reserve Ratio (CRR- impounding of bank funds) as a monetary tool . Such measures have been quite successful in the past but now with increasing international money flows it has started becoming ineffective or, sometimes, counter-effective.

    In the present case also, Reserve Bank’s steps on CRR resulted in a negative liquidity situation which the CB is now trying to address through a series of steps which are quite roundabout in nature and may lead to other monetary problems in future. I believe it would have been more appropriate to reverse the earlier mis-steps on CRR instead.

  5. Sir,

    I fail to understand what current (monetary) state of the economy is. Do we have excess liquidity or is there a lack of liquidity? Rate increases seem to indicate that liquidity is excess (or atleast the RBI thinks so) – the standard reason quoted for inflation. However, if liquidity is negative, the question is – where has all the money gone? If it is with the govt, why is the govt still borrowing? Are there FIs not controlled by the RBI who have it?

    When the RBI increases rates / CRR, the indication is that banks should reduce loans and increase deposits. If increase in deposits is still lower than in loans, doesn’t this mean that the rates are too low? Shouldn’t the RBI have increased interest rates by a higher amount? Lastly, is it likely that banks are resisting increasing interest rates fearing something (say increase in bad debts)?

  6. Nirmesh,

    Firstly, there is no excess liquidity in the system. In fact, even yesterday banks borrowed Rs. 130 billlion from RBI through overnight repo. The policy rate increases are aimed at at making credit more expensive ( and yes, savings more lucrative). Yet, liquidity is negative partiallly because RBI impounded funds through increase of CRR twice in 2010. As to the question, why a surplus Government is still borrowing, that is anybody’s guess. The question has been raised in the article also. Maybe they are planning to use the surpluses for social expenditure.

    Banks have increased interest rates quite sharply over the past one year. Yet inflation is still raging not because the rates have not been increased high enough but because of the fact that much of the basket causing high inflation is price inelastic ( the issue is discussed in a forthcoming article). Moreover, perhaps, monetary policy is becoming somewhat ineffective in the face of global fund flows.

Comments are closed.