RBI's liquidity policy:
A fine balance The new grammar of liquidity proposed by RBI is a challenge for itself as it now needs to demonstrate the same dexterity in its liquidity stance which can tougher as forecasts of currency withdrawal by the public, of dollar flows, and of government’s unspent cash surplus can at best be approximate.The monetary policy announced on April 5th is a landmark one, in that it changes the fundamental principle by which the Reserve Bank of India (RBI) approached liquidity management.
This far RBI’s day-to-day liquidity management - underpinned by the Mohanty committee’s and the Urjit Patel committee’s recommendations - was based on the belief that monetary policy can be transmitted only if the system is kept short on liquidity. The RBI effectively dissociated itself from this philosophy. Of course, the governor and the deputy governor have argued that the change in attitude to liquidity is also because the RBI has developed better marksmanship and has more instruments now in the form of variable rate repos and reverse repos to keep liquidity in balance.
Nevertheless both men deserve credit for their willingness to change their stance. That said, the jury is still out on how and how much the new ideology will work. In that sense, Indian debt markets start an interesting journey. Let us break this up for what it means to the economy and the citizen. This far the RBI only cut its repo rate to signal to bankers to cut theirs. But it kept bankers seriously dependent on the RBI to fulfil their fundamental obligation of meeting their CRR targets by maintaining a liquidity shortage in the banking system.
When banks are borrowing nearly 2 lakh crore rupees everyday to meet their cash reserve ratio (CRR) limits, all traded instruments in the debt market remain 'biddish', that is yields don’t fall simply because demand for money is more than the supply. Now with the promise of sufficient enduring liquidity, all short term and long term yields – on treasury bills, certificates of deposit, government bonds, commercial paper and even cash-tom – ought to ease. As the governor said, the rate cut may be 25 basis points, but it adds up to much more. The retail and corporate borrower may in due course find the cost of money falling much more than just a quarter percentage point. That said, this new grammar of liquidity proposed by RBI comes with its own challenges for the RBI itself. This far the central bank has balanced neatly between being too dovish and too hawkish on its inflation stance. It now needs to demonstrate the same dexterity in its liquidity stance.
This can be tougher since forecasts of currency withdrawal by the public, of dollar flows, and of government’s unspent cash surplus can at best be approximate. There is also a moral hazard of excessive sovereign indulgence. The governor said the RBI plans to infuse Rs 15,000-20,000 crore of liquidity every month. If there aren’t sufficient dollar inflows to buy, it will have to buy government bonds. In addition it has to bridge last year’s liquidity deficit of 90,000 crores. This possibly implies bond purchases of nearly Rs 3.3 lakh crore. Such a large purchase, even if spread over the year, can distort yields. In a sense this appears to be a quid-pro-quo with the government – Government adhered to the fiscal deficit target; so why not return the favour! Also, this favour from the RBI can’t have come at a more opportune time for the state governments, most of whom will continue to flood the market with their UDAY and other bonds. Excessive indulgence of government issuances during the Subbarao regime was at least partly responsible for the fiscal profligacy and the double digit inflation in those years. In a way, it was the fear of bond yields climbing to 8 percent and above that chastised the Modi government into keeping its deficit to 3.5% in the recent budget. RBI needs to ensure that this market discipline continues on the central and state governments
. As well, the RBI needs to separate the deficit caused by government’s unspent balances from the more enduring deficit caused by currency leakage. That is the unaddressed issue in the bi-monthly policy. RBI and the government need to put their heads together and address this problem either by agreeing to auction government’s cash balances or arriving at a way of automatic cancellation of T-bill auctions when cash balances exceed a certain limit or both. It will be sad if the government’s volatile cash balances sabotage an interesting experiment of balanced liquidity that the RBI is embarking on.
The RBI also needs to put bankers on notice. It has reversed a long standing principle of liquidity management to help bankers cut rates. If banks behave like cartels, the RBI needs to talk tough. As well, if market yields don’t fall much, the RBI must call the market’s bluff, and at all costs the RBI must not lose the hard won gains on inflation control. It’s a pity that the policy has been apparently lost on stock markets. But if it works through the debt markets in the way it is intended to, it can have a beneficial impact on the economy and ultimately on stock markets as well.
Read more for Best Stock Tips-http://www.aceinvestmentadvisory.com
A fine balance The new grammar of liquidity proposed by RBI is a challenge for itself as it now needs to demonstrate the same dexterity in its liquidity stance which can tougher as forecasts of currency withdrawal by the public, of dollar flows, and of government’s unspent cash surplus can at best be approximate.The monetary policy announced on April 5th is a landmark one, in that it changes the fundamental principle by which the Reserve Bank of India (RBI) approached liquidity management.
This far RBI’s day-to-day liquidity management - underpinned by the Mohanty committee’s and the Urjit Patel committee’s recommendations - was based on the belief that monetary policy can be transmitted only if the system is kept short on liquidity. The RBI effectively dissociated itself from this philosophy. Of course, the governor and the deputy governor have argued that the change in attitude to liquidity is also because the RBI has developed better marksmanship and has more instruments now in the form of variable rate repos and reverse repos to keep liquidity in balance.
Nevertheless both men deserve credit for their willingness to change their stance. That said, the jury is still out on how and how much the new ideology will work. In that sense, Indian debt markets start an interesting journey. Let us break this up for what it means to the economy and the citizen. This far the RBI only cut its repo rate to signal to bankers to cut theirs. But it kept bankers seriously dependent on the RBI to fulfil their fundamental obligation of meeting their CRR targets by maintaining a liquidity shortage in the banking system.
When banks are borrowing nearly 2 lakh crore rupees everyday to meet their cash reserve ratio (CRR) limits, all traded instruments in the debt market remain 'biddish', that is yields don’t fall simply because demand for money is more than the supply. Now with the promise of sufficient enduring liquidity, all short term and long term yields – on treasury bills, certificates of deposit, government bonds, commercial paper and even cash-tom – ought to ease. As the governor said, the rate cut may be 25 basis points, but it adds up to much more. The retail and corporate borrower may in due course find the cost of money falling much more than just a quarter percentage point. That said, this new grammar of liquidity proposed by RBI comes with its own challenges for the RBI itself. This far the central bank has balanced neatly between being too dovish and too hawkish on its inflation stance. It now needs to demonstrate the same dexterity in its liquidity stance.
This can be tougher since forecasts of currency withdrawal by the public, of dollar flows, and of government’s unspent cash surplus can at best be approximate. There is also a moral hazard of excessive sovereign indulgence. The governor said the RBI plans to infuse Rs 15,000-20,000 crore of liquidity every month. If there aren’t sufficient dollar inflows to buy, it will have to buy government bonds. In addition it has to bridge last year’s liquidity deficit of 90,000 crores. This possibly implies bond purchases of nearly Rs 3.3 lakh crore. Such a large purchase, even if spread over the year, can distort yields. In a sense this appears to be a quid-pro-quo with the government – Government adhered to the fiscal deficit target; so why not return the favour! Also, this favour from the RBI can’t have come at a more opportune time for the state governments, most of whom will continue to flood the market with their UDAY and other bonds. Excessive indulgence of government issuances during the Subbarao regime was at least partly responsible for the fiscal profligacy and the double digit inflation in those years. In a way, it was the fear of bond yields climbing to 8 percent and above that chastised the Modi government into keeping its deficit to 3.5% in the recent budget. RBI needs to ensure that this market discipline continues on the central and state governments
. As well, the RBI needs to separate the deficit caused by government’s unspent balances from the more enduring deficit caused by currency leakage. That is the unaddressed issue in the bi-monthly policy. RBI and the government need to put their heads together and address this problem either by agreeing to auction government’s cash balances or arriving at a way of automatic cancellation of T-bill auctions when cash balances exceed a certain limit or both. It will be sad if the government’s volatile cash balances sabotage an interesting experiment of balanced liquidity that the RBI is embarking on.
The RBI also needs to put bankers on notice. It has reversed a long standing principle of liquidity management to help bankers cut rates. If banks behave like cartels, the RBI needs to talk tough. As well, if market yields don’t fall much, the RBI must call the market’s bluff, and at all costs the RBI must not lose the hard won gains on inflation control. It’s a pity that the policy has been apparently lost on stock markets. But if it works through the debt markets in the way it is intended to, it can have a beneficial impact on the economy and ultimately on stock markets as well.
Read more for Best Stock Tips-http://www.aceinvestmentadvisory.com
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