More liquidity than system needs

More liquidity than system needs
The Hindu Business Line, September 18, 2009, Page 8

RBI Annual Report 2008-09.

The official response to the emerging crisis a year ago was a massive unwarranted release of liquidity. Much of the money has been making a round trip to the RBI through reverse repos. And now the chickens are coming home to roost, says A. SESHAN.

There is no satisfactory explanation why interest rates have not fallen as much as expected despite the strategy of flooding the economy with money.

The much-awaited Annual Report of the Reserve Bank of India (RBI) recounts the story of the economy that has already been told — starting with the Economic Survey and followed up by Quarterly Reviews of the central bank and the other reports of Indian and international institutions.

Still, it is a valuable addition to the existing literature on the economy, being a convenient one-stop source of information and data and carrying the imprimatur of the Central Board of Directors with data not available elsewhere (e.g. the balance sheet and organisational matters of the Bank).

Like other RBI publications, it is rated highly for its authenticity, even if one does not agree with its interpretations of data. While this reviewer is in broad agreement with many of the observations in the Report, he would like to point out a few exceptions.

Liquidity in West and India

The whole thrust of monetary policy everywhere is on ensuring adequate liquidity to service the requirements of the economic system. In the aftermath of the sub-prime crisis in the West, the damage to both funding and market liquidity persisted for many days.

The severity of the crisis of confidence can be gauged from the fact that the spreads in respect of LIBOR-OIS and TED (difference between the three-month T-bill interest rate and three-month LIBOR) reached the record levels of 364 basis points (one basis point equals one-hundredth of a percentage point) and 465 basis points, respectively, in October 2008.

Historically, in normal times, the spreads hover around 10 and 30 bps, respectively. It was in that context that central banks, especially the US Federal Reserve, had to intervene massively and in unconventional ways to deal with the unusual situation so that the wheels of the financial system were lubricated.

As a result, funds have started flowing and the LIBOR-OIS spread has come down now to 25 basis points that is even below the Greenspan benchmark of 50 basis points in normal times.

During September-October of 2008, there was a liquidity problem in India due to the drying up of foreign sources of credit and capital outflows coupled with advance tax payments. It was further aggravated by the RBI intervention in the forex market selling dollars and absorbing rupees in order to arrest the depreciation of the domestic currency. Otherwise, the country was not in any big way exposed to the sub-prime loan losses.

Foreign currency assets of the RBI fell from $286.12 billion on August 29, 2008 to $274.91 billion on October 3. Of the total decline of $11.21 billion, around two-thirds ($7.7 billion) occurred in the week ended October 3. It is safe to assume that the bulk of it would have been due to market intervention sucking out rupees of a massive magnitude.

Unwarranted action

Till September 26, 2008, non-food credit growth rose during the financial year by 7.8 per cent from 6.1 per cent in the corresponding previous fiscal. Aggregate accommodation including credit and investments in the corporate sector rose by 7.4 per cent from end-March to end-September 2008 against 5.5 per cent in the earlier year. The investment in SLR securities as a proportion of aggregate deposit liabilities was lower at 28.7 per cent than a year back (31.7 per cent) obviously due to disinvestment to finance credit. It was still above the minimum SLR of 25 per cent.

Cash reserve ratio stood at 9.91 per cent barely enough to maintain the statutory minimum and the level of settlement balances for inter-bank clearing.

As a consequence, there was a shortage of liquidity in the money market. The call money rate ruled considerably above the repo rate, sometimes touching 20-plus level. The banks had large-sized access to the RBI for repo operations. The problem was with the call money, and not the credit market. Call money is required for several reasons, only one of which is loans and advances of banks.

The official response to the emerging crisis was a massive unwarranted release of liquidity by the government (through fiscal reliefs) and the Bank, adding up to 7.4 per cent of Gross Domestic Product till the end of March. Much of the money has been making a round trip to the RBI through Reverse Repos, being surplus to the system’s needs. Now the chickens are coming home to roost. A medium-sized lemon costs Rs 5 in Mumbai! There has been no general recession in the economy unlike in the West. Only the growth rate of Gross Domestic Product has been affected. Even then an expected rate of around, say, 6 per cent, is no small matter

Trends in Interest Rates

There is no satisfactory explanation as to why, unlike in the West, interest rates have not come down in India as much as the central bank would like to see in relation to the large cuts it has effected in policy rates despite the common strategy of flooding the economy with money.

What is more, as a pointer to the future, bond rates in the gilt-edged market have been firm. The attempt of the RBI to enter the market to purchase government securities injecting funds that would facilitate subscription to new issues at low yields has not been successful.

Between April 9 and September 10, it sought to buy securities worth Rs 79,500 crore but could do so only to the extent of Rs 50,991 crore (64.1 per cent).

In the auctions conducted so far the Bid-Cover Ratio was below 2 in 9 out of 13 occasions, the one on September 4 touching the nadir of 1.04 per cent. (A ratio of 2 and above indicates a good demand.). The price bids were generally high and a large proportion had to be rejected.

As a result, yields are hardening for buy-backs in alternate weeks that set the benchmarks for the succeeding sale of new securities. It is exactly the opposite of what the central bank wants to achieve.

At the same time, there are massive Reverse Repo (RR) operations of banks with the RBI in excess of Rs 1 lakh crore continuously since the beginning of the current year. There have been reports of arbitrage with dollar as a carry-currency instead of yen. Does it also explain the roller coaster drive of the rupee vis-À-vis the dollar?

Why should banks prefer the RR rate of 3.25 per cent as against much the higher coupons offered on long-term securities? It has to do with market psychology and strategy. Due to the drought prevailing now there is a strong expectation of rates going up before the end of the year due to the additional borrowings of the Centre over and above what has already been announced in the Budget.

The permission given to States to raise an additional amount of Rs 21,000 crore exacerbates the situation. Hence, banks do not want to face the risk of a depreciation of their portfolios.

The strategy of banks now is to sell high and buy low in the so-called open market operations. They would be happy if the RBI continues with the buybacks. As the Americans say, a sucker is born every minute! Why should the banks give up their securities unless the prices are attractive as they can deposit the proceeds only in RR at 3.25 per cent in the absence of adequate demand for credit?

(The author is an economic consultant based in Mumbai. blfeedback@thehindu.co.in)