RBI May Use Short Term Bills To Sterilise Liquidity

RBI’s G-sec holding may compel it to look for alternatives to sterilise the liquidity.

People stand in line to exchange Indian five hundred and one thousand rupee banknotes outside the Reserve Bank of India (RBI) headquarters in New Delhi, India (Photographer: Anindito Mukherjee/Bloomberg)  
People stand in line to exchange Indian five hundred and one thousand rupee banknotes outside the Reserve Bank of India (RBI) headquarters in New Delhi, India (Photographer: Anindito Mukherjee/Bloomberg)  

The amount of government securities available with the Reserve Bank of India to offer banks in exchange of the spurt in deposits is nearing a critical limit, which may force the central bank to look at alternative means to sterilise liquidity, says India Ratings and Research.

In India Rating’s assessment, sterilisation through the issuance of cash management bills is likely to be preferred over other structural measures, namely a hike in the cash reserve ratio or resorting to the use of the market stabilisation scheme, since the sustainability of such high deposits remains uncertain. The sterilisation will ensure stability in the money market in sync with the central banks key objective of ensuring financial market stability.

Banks have parked a record Rs 4.3 lakh crore with the RBI as of November 22, 2016, against which the banks receive government securities.

However, RBI’s G-Sec holding currently stands at around Rs 7 lakh crore, which may compel the central bank to look for alternatives to sterilise the liquidity in the near-term.

A fortnight after the government notified the withdrawal of the legal tender status of high denomination currency notes, banks find themselves flooded with a gush of liquidity.

As on November 22, 2016, on a net basis, banks have parked a record Rs 4.3 lakh crore with the RBI – earning in range of 6.21 percent to 6.24 percent as overnight interest. This is the highest liquidity absorption carried out by RBI (earlier record absorption was Rs 1.7 lakh crore in May 2009).

In order to absorb that liquidity, the RBI tenders G-Sec as collateral (under the liquidity adjustment facility window) by conducting reverse repo operations.

RBI’s Options

The average amount that banks have been parking with the RBI since November 9, 2016 is Rs 1.75 lakh crore compared to the last three months average pre-demonitisation of Rs 25,600 crore. India Ratings believes, in the event that the liquidity surplus in the system increases beyond the level of G-Secs held by RBI, several alternative and unconventional measures can be deployed.

The issuance of cash management bills is likely to emerge as the preferred alternative for the RBI owing to benefits like

1) short duration of underlying security, less than 91 days
2) existing secondary market and qualification for a ready forward facility and investment in Statutory Liquidity Ratio
3) consistent with RBI’s stance on liquidity and monetary policy.

The issuance of cash management bills will limit the softening of yields, especially on the shorter end of the curve. Traditionally, such bills are issued to enable the government to tide over temporary liquidity mismatches. India Ratings, however, believes given the current scenario it can be an effective liquidity management tool for the RBI.

Apart from cash management issuances, the RBI could also look at other options to durably sterilise liquidity:

  • Utilisation of market stabilisation scheme limits to issue bonds – the ceiling for which is fixed at Rs 30,000 crore for financial year 2016-17.
  • Increasing reserve requirement by hike in cash reserve ratio – a mode less preferred given its permanent nature and perverse impact on banks’ ability to ensure transmission.
  • Intervene in the forex market - RBI has accumulated $10.7 billion through spot market in April-September 2016.
  • Explore the option of uncollateralised window of liquidity absorption (standing deposit facility as proposed in the ‘Report of Expert Committee to Revise and Strengthen Monetary Policy Framework’.)
  • Introduce reward based excess reserve maintenance as introduced by the U.S. Federal Reserve in 2009. This encourages commercial banks to park excess liquidity in the hands of central banks with nominal interest rate, creating an alternative tool for non-collateral sterilisation.

The Implications

However, the agency believes each of the above measure comes with its own set of implication and limit the fluidity required for the central bank operation. The market stabilisation scheme bonds may pose a challenge with respect to eventual de-sequestration, while a hike in cash reserve ratio may result in a negative shock to the banking system – limiting their ability to pass on easy rates. On the other hand, intervention in the foreign exchange market will necessitate RBI to utilise their forex reserves. Given the global risk aversion and elevated probability of a Fed rate hike, the ensuing currency volatility may compel RBI to preserve forex reserves and utilise it judiciously. Lastly, in order to operationalise the standing deposit facility (uncollateralised liquidity absorption facility, as proposed by Urjit Patel committee in 2014), an amendment in the RBI Act is required - thus prohibiting its immediate utilisation.

(India Ratings and Research, a wholly owned subsidiary of Fitch Group, is a SEBI and RBI accredited credit rating agency operating in the Indian credit market.)