Updated: December 10, 2021 6:47:17 am
As expected, given the pervasive uncertainty following the Omicron variant, the Monetary Policy Committee (MPC) voted to maintain status quo on policy rates, with one member continuing to dissent on the “accommodative” stance of policy. The repo rate is maintained at 4 per cent and the reverse repo rate at 3.35 per cent. Forecasts of FY22 GDP growth and CPI inflation are retained at 9.5 per cent and 5.3 per cent, respectively.
The major expectation had been a move towards policy “normalisation”, and there indeed seems to be a subtle shift in policy guidance towards this objective. While the need for durable growth remains paramount, the statement suggests a somewhat greater emphasis on both anchoring inflation and addressing potential financial stability risks arising from policy tightening of global central banks.
Since the onset of the Covid-related lockdowns, RBI had moved proactively to cut the repo and reverse repo rate and inject unprecedented amounts of funds into banks and other intermediaries. The excess liquidity in the financial system had increased from average surplus levels of around Rs 2-3 lakh crores daily in March ‘20 to around Rs 6-8 lakh crores. This had served to push short-term market interest rates down to the reverse repo rate, and occasionally much below. In addition, both the repo and reverse repo rates had been cut to 4.0 and 3.35 per cent, respectively, with the gap – the “corridor” – between the rates widening from the usual 25 basis points to 65 bps.
A central bank’s main role in modern monetary policy operating procedures is to determine the basic overnight interest rate, deemed to be consistent with prevailing macroeconomic conditions and their economic policy objectives, in balancing the ecosystem for sustained growth together with moderate inflation (“price stability”). This is achieved through buying and selling very short-term (predominantly overnight) funds (mainly) from banks to keep a specified operating rate (the weighted average call rate in our case) very close to the policy rate.
Post February ’20, a combination of the lower reverse repo rate and the large liquidity injection had resulted in a drop in various short-term rates down to (and occasionally below) the reverse repo rate, making it the effective operating rate of monetary policy. While this might have been appropriate during the initial phases of the crisis, this can potentially now create risks to the financial stability objective.
Liquidity management in the extended banking and financial system (which includes non-banking intermediaries like NBFCs, mutual funds and others) will now be the key pillar of normalisation. This will involve calibrating both the volumes of the surplus funds in the system, as well as the associated price of this liquidity (i.e., interest rates). Note that this process is the domain of RBI and not MPC. These operations will be conducted within RBI’s liquidity management framework.
RBI has dynamically used multiple instruments to absorb this liquidity surplus over the course of the year. However, this is likely to be a slow process. There are two sources of liquidity additions: (i) exogenous, which are largely due to inflows of foreign currency funds to the extent that they are absorbed by RBI and outflows of currency in circulation (cash) from the banking sector, and (ii) voluntary or endogenous, which is the result of the creation of base money by RBI through buying and selling of bonds, thereby injecting or extracting rupee funds. Post the October review, RBI had stopped buying bonds under the Govt Securities Asset Purchase (GSAP) and done negligible Open Market Operations (OMOs), thereby stopping addition of voluntary liquidity injection into the system, our own version of “tapering”. Union government balances with RBI, arising from cash flow mismatches between receipts and expenditures, has hybrid characteristics and also impacts liquidity.
How can the surplus system liquidity overhang be managed? RBI has used the reverse repo window to absorb almost all this liquidity surplus from banks. It has again allowed banks the option to prepay the outstanding borrowings from the Targeted Long Term Repo Operations (TLTROs), thereby potentially extracting another Rs 70,000 crores. These will anyway eventually mature in 2023.
On interest rates, RBI – post the October review – has gradually guided short-term rates up with a sure hand from near the reverse repo rate to close to the repo rate. It has shifted its liquidity absorption operations from the predominant use of fixed rate reverse repos (FRRR) into (largely) 14-day variable rate reverse repo (VRRR) auctions to guide a rise in interest rates. Since the beginning of 2021, the weighted average rate on the VRRR auctions had hovered around 3.4 per cent. Since early October, these rates had steadily moved up in a smooth and orderly fashion up to 3.75-3.9 per cent following RBI acceptance at these auctions, close to the “normal” reverse repo levels.
The VRRR rates moving up have also resulted in various short-term funding interest rates like 90-day Treasury Bills, Commercial Papers (CP) and banks’ Certificates of Deposits (CD) moving up from the reverse repo rate or below in September to 3.5 per cent and higher since December. The OMO and GSAP operations have also helped in managing medium- and longer-term interest rates in the yield curve.
There is a likelihood of further additions to exogenous system liquidity, largely through foreign currency funds inflow, particularly in FY23. There might consequently be a need for other instruments to absorb these surpluses apart from VRRR auctions. These options will depend on the various trade-offs and policy choices. Managing liquidity surpluses of the non-banking intermediaries, especially mutual funds, will be another challenge, since they do not have direct access to VRRR operations.
The next steps in sequencing of the normalisation phase will likely be reverse repo rate hikes, followed by a change in stance from “accommodative” to “neutral”. The subsequent shift to the tightening phase, with hikes in the repo rate, is likely towards the late months of FY23, with shifts “if warranted by changes in the economic outlook”.
This column first appeared in the print edition on December 9, 2021 under the title ‘The liquidity challenge’. The writer is executive vice-president and chief economist, Axis Bank. Views are personal.
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