Time for a fresh look at RBI's liquidity management framework

Tight liquidity is the single biggest complaint of all bankers, NBFC honchos and even corporates, who were interviewed by journalists in Davos. This is a bit unusual. Corporates normally demand lower interest rates. Govt-RBI tussles are also usually over interest rates - ie the price of money, not the stock of money. The RBI too, in the past two weeks has become hyper-active on the issue: as of last Friday it has used the full suite of its tools to provide liquidity - it purchased Rs 10,000 cr of bonds via an OMO (open market operations); provided Rs 1.62 lk cr via 14-day repo and 2 lakh cr via daily repo all in one day. Given that tight liquidity has emerged as a central issue, this note argues that the time may have come to set up a high powered committee in and by the RBI to draw lessons from the recent liquidity crunch, go into all aspects of liquidity management by the RBI and, if needed, suggest a new framework or new tools to manage liquidity

To cut back to the problem at hand, in India today, despite the growth slowdown, interest rates are being discussed much less than liquidity. Since Dec 16, the interbank market or the LAF system has been running a daily liquidity deficit of over Rs 1 lakh crore ( barring a couple of days in early Jan) ; since Jan 4 the daily deficit has consistently crossed 2 lakh crore rupees and as of Thursday, Jan 23, the liquidity deficit in the interbank market has touched 3.3 trillion rupees, the highest since 2010, say some dealers. What is worse the overall system liquidity ( counting govt cash balance plus interbank liquidity) which used to be a surplus of 3 and 4 lakh crore for the better part of last 2 years, was down to Rs 64,350 cr as on Dec 27, ( the last date for which RBI provided data).

The immediate reason for the rapid fall in interbank liquidity and overall system or durable liquidity is the huge intervention by the Reserve Bank to soften the fall of the rupee-dollar exchange rate as foreign funds aggressively sell Indian equities and buy dollars to repatriate back to their home country. Foreign funds have net sold 8.2 billion dollars of Indian stocks & bonds so far in january. December FPIs net bought around $1.8 bn of bonds & equity, but net sold $2.5 bn in November and $11.2 bn in October' 24. To mitigate the torrential outflow of dollars, ,. the RBI has sold dollars heavily bringing down its FX reserves from over 700 billion in early October to $623 billion as of mid January. All RBI dollar sales imply that an equivalent amount of rupee liquidity goes out of the market.The RBI has been responding. On Dec 8 it cut the cash reserve ratio (the percentage of their deposits that banks must keep as idle cash with the RBi) from 4.5% to 4%, thus releasing 1.13 trillion rupees in one shot. In course of time , the CRR cut will result in more liquidity as banks take in more deposits and give out more loans, But that's the catch. Credit is not growing fast enough due to the liquidity deficit. The RBI last week , probably realised that its traditional system of 7-day and 14-day repos through which it was giving cash to the market, won't be enough any more, On Jan 15 it announced that it will do daily repos to give rs 50,000 cr. The offered amount had to be raised to 1.25lakh crore by Monday Jan 20 , and to Rs 2 lk cr by Friday.

This is in addition to the longer term repos and the Fx swaps through which also the RBI is providing liquidity.While the overall durable liquidity has shrunk only in December, the interbank liquidity has been intermittently tight for the past couple of years. One of the key reasons has been the government's unspent cash balances, which tend to rise sharply around the time of advance tax and GST payments.

Actually there have been a bunch of one-off factors pushing up the demand for deposits in the banking system:

1. Firstly, in August 2024 HDFC, the housing finance giant merged into HDFC Bank and the bank has since been replacing HDFC’s maturing loans with deposits, upping the ante for deposits.

2. Secondly, the government has, since FY24 introduced a just-in-time payment system for funding states for central schemes. This has resulted in a lot of idle cash lying with the government and outside the banking system, Ten states were migrated to the just-in-time portal ( called SNA or single nodal account portal) in Fy24, a further 18 are being migrated this year. state owned banks like SBI which have the state government accounts , in days of yore head plenty of idle govt deposits, which have thinned and vanished in the past 2 years, leading to even the mighty SBI joining the competition for deposits, thus pushing up rates.3. Electronic modes of payment - First RTGS, then NEFT and now UPI, are leading to sudden demands for cash in banks, making banks want to keep more idle deposits handy.

4. The RBI put out draft rules increasing banks' LCR requirements i.e. it wants banks to keep more cash in near liquid form like govt bonds, because of rising share of unstable deposits. Bankers say this will lock in an incremental Rs4 lakh cr in govt bonds, reducing the amounts available for lending and thus increasing the hunt for deposits.

5. Bank FD holders have turned mutual fund investors in growing numbers, and while the cash still remains in bank accounts, banks see lesser demand for long term FDs and are forced to pay more interest on such term deposits.

6. The RBI also tightened liquidity since August 2023, in part because of high inflation. Later that year, it warned against a hectic 30% growth in unsecured loans and increased risk weights on these loans to slow them down.

The banking system was thus already feeling the pinch of costly deposits for at least 15 months when the Trump-tariff threat and fleeing of FPI dollars from Indian markets squeezed liquidity to choking point.

The all round tightness is leading to all kinds of accusations. The RBI's completely defensible moves to tighten unsecured loans has been blamed as witch hunting. The central bank has also been blamed for not cutting interest rates though even its critics will agree that inflation has remained way above its mandated 4% for many years now. The inflation targeting framework itself has come for justified criticism on grounds that non food or core inflation has fallen below 4% for over a year now, but the central bank is not cutting rates because of high food inflation, which anyways can't be controlled by high interest rates.

Economists and bankers are also forwarding a bunch of band-aid solutions: some are asking for more CRR cuts. Some are asking that the banks' CRR balances be adjusted against their LCR requirement ( LCR rules requires that banks keep one month's expected outflows in cash or near cash instruments like government bonds)

Given these high pitched noises, accusations and suggestions, it may be appropriate for RBI to set a high powered committee to study the entire issue of liquidity vis a vis the RBI's inflation and growth mandate. When Raghuram Rajan became RBI governor, he inherited an economy that was struggling under near double digit inflation for 4 years and he answered the problem by appointing the Urjit Patel Committee on inflation targeting which recommended the inflation targeting framework.

But after 8 years of the inflation targeting framework, it may be a good time to review if the management of the liquidity framework to achieve the desired interest rate is working well.

The idea is not to abandon the flexible inflation targeting (or FIT) framework, which has served the country well. The idea is more to lay more emphasis on the "flexible" part. The RBI's mandate as per the frame work is to keep inflation close to 4%, while supporting growth. Given the recent experience, all reasonable persons will agree that RBI's mandate of both growth and inflation are impacted by liquidity and by rates. : Insufficient liquidity can restrict credit availability, stifle growth and even lead to deflationary pressures while excessive liquidity can overheat the economy, leading to unsustainable growth and high inflation. The Urjit Patel committee too , in its recommendations recognised the role of liquidity. It recommended that liquidity be kept surplus in a rate cutting cycle and be kept deficit in a rate hiking cycle.With new issues like rapid 24x7 payment systems, changing trade dynamics, new LCR rules and more Indian bank FD savers turning stock market investors, a new committee on liquidity can approach the issue afresh and recommend smarter ways of managing interbank liquidity to achieve the desired interest rates, inflation and growth.