The liquidity bulge in the banking system is keeping all stakeholders busy. The recent discussion on introducing a special deposit facility (SDF) for managing surplus-banking liquidity bears testimony to this fact. We, however, believe that some simple amendments in monetary management policies by the apex bank will be a win-win for government and banks.
In April 2016, the Reserve Bank of India (RBI) made a well thought out departure in monetary policy from a rate stance to a liquidity neutral strategy. However, the full benefit of structural liquidity injection remained elusive due to two reasons. First, because of the downward rigidity on overnight rates through reduction in corridor between repo and reverse repo from 100 to 50 basis point (bps). Second, the RBI’s absorption of frictional liquidity surplus primarily through term reverse repo—only 0.25% of net demand and time liability (NDTL) at normal reverse repo rate of 5.75%—with ceiling pegged as high as repo rate also denied softening of the operative overnight rate.
The system was operating perfectly at a neutral to marginal surplus liquidity environment till the time of demonetisation in November. Demonetisation led to an abnormal surge in frictional liquidity.
To address the urgent need for sterilization of the abnormal surge in liquidity, the market stabilization scheme (MSS) limit was hiked to Rs6 trillion. Under MSS, issuance of cash-management bills (CMBs) absorbed entire frictional liquidity, but elevated short-term rates. Besides putting pressure on government finances in the form of higher interest expense, this move substantially reduced demand for long-dated bonds thereby creating the effect of partial crowding out for the debt-burdened private sector.
However, the government’s commitment towards fiscal consolidation in the Union budget in February, coupled with the emphatic win of the Bharatiya Janata Party in states, has resulted in sizeable foreign flows leading to rupee appreciation. Subsequently, checking such appreciating bias coupled with low credit growth has again resulted in surplus liquidity. Sterilizing this liquidity at an optimal cost poses a new challenge for the government as well as the central bank. With the government focusing now on growth and employment generation, it is of utmost importance to consider innovative ways to usher in a lower term structure of interest rates, an essential sine qua non for economic recovery.
For this to happen, our fundamental premise is to have a favourable demand-supply balance for government bonds. We propose to achieve this by creating a financial architecture through increasing the demand for bonds and simultaneously reducing the supply and reducing downward rigidity on operative overnight rates. This will have the desired objective of pushing down interest rates through an increase in bond prices.
First, for increasing the demand for bonds, we should have the necessary amendment in the RBI Act so that the conduct of reverse repo and term reverse repo operations are completely non-collateralized. As lending to the central bank has no credit risk, there is no need to provide government securities. Since securities obtained under reverse repo were eligible for statutory liquidity ratio (SLR), it will thus ensure an overall increase in the demand for bonds.
Second, like the cap in injection of liquidity through term repo and repo under the liquidity adjustment facility (presently, the combined limit is up to 1% of the NDTL), we can also have a cap on absorption of liquidity by the central bank (the combined limit of term reverse repo and reverse repo can be placed at 1% of NDTL or otherwise with occasional deviation). Uncollateralized restricted absorption by the central bank will pave the way for the government to suck out excess liquidity at lower cost (can be capped marginally lower than the reverse repo rate or as deemed fit) through SDF.
Interestingly, since both SDF and reverse repo are proposed to be collateral-free under our recommended monetary dispensation, this will justify an SDF rate-setting lower than the reverse repo rate. Also, this move will ensure a lower supply of government bonds through less issuance of CMBs.
The above-mentioned architecture is likely to benefit the economy through multiple channels. First, the absorption of additional surplus liquidity at a lower rate through SDF will pull down the operative overnight rate.
Second, higher SDF collections may help government reduce its short-term treasury bill borrowings, thereby reducing short-term rates and the total supply of government paper.
Third, a lower operative overnight, short-term rate, lower supply and generation of additional demand will bring down the yield of long-dated government bonds, thereby pulling down the sovereign yield curve. This will immensely help the banks to create a provisioning buffer in the midst of balance-sheet cleaning.
Fourth, lower cost of borrowing through sterilization will lower interest costs, thereby helping the government to keep its finances under control.
Fifth, if government channels its savings of financing cost into infrastructure spending, it will provide a crowding-in effect.
Lastly, lower overall rate structure for government bonds will help debt-burdened companies replace existing high-cost debt with low-cost and fresh borrowing, thereby providing some relief on the non-performing asset front as well.
Soumya Kanti Ghosh and Ramkamal Samanta are, respectively, group chief economic adviser, State Bank of India, and vice-president (treasury), SBI-DFHI.
