Reserve Bank of India juggles liquidity ops under revised framework

Conducts special variable rate repo operation to ease tight liquidity situation

The Reserve Bank of India (RBI) on Friday once again conducted a special variable rate repo operation to ease the tight liquidity in the system caused by the larger-than-expected goods and services tax (GST) collection. The central bank offered Rs 75,000 crore to banks, against which they submitted bid worth Rs 1.22 trillion. The cut-off was 4.09 per cent, above the repo rate of 4 per cent. Weighted average call money rates in the interbank market pushed up to a near two-year high of 4.44 per cent.

Observers say this is temporary and is in sync with the revised liquidity framework that it adopted in February 2020, becoming fully active from the beginning of the year. The framework suggests that the liquidity adjustment facility (LAF) of the RBI will move more towards 14 days, and if it causes temporary shortages or excesses, that can be smoothened out through another set of liquidity operations of overnight and up to 13 days, as required.

“There is a method in why the central bank is conducting dated variable rate reverse repo (VRRR) auctions, and then the opposite shorter-term variable rate repo operations. As the path of liquidity management unravels, one can see that it is exactly on desired lines and achieving milestones in a timely fashion,” said a senior economist and central banking expert.

Experts say the aim is to push banks towards forming a medium-term view of liquidity, rather than making do with an overnight view, which hinders proper development of the rates market. Unless a medium-term view on liquidity is formed, there will be no view on the long-term rates, which will stifle the development of a term money market and hinder effective policy transmission. “We should not call this tight system liquidity, rather, it’s encouraging to note that the RBI has achieved normalcy in the contour of banking system liquidity without touching the reverse repo rate and without disrupting the markets,” said Soumyajit Niyogi, associate director at India Ratings and Research.

“The RBI has changed the nature of liquidity through VRRR without permanent sterilisation. The money is still in the banking system but impounded. The prevalent friction in the short-term rate within a narrow band is healthy, and the inter-temporal choice by the banks develops term premia. Sustained abundant system liquidity endangers stability in the financial market,” said Niyogi.

Such simultaneous operations have been practised in large central banks like the European Central Bank to meet the different demands of banks facing asymmetric liquidity distribution profiles. In India, too, public sector banks are usually liquidity surplus at the expense of smaller PSBs because depositors tend to put their money more in government banks.

As a result, the back-to-back variable rate repo auctions were designed to “rebalance liquidity conditions in a non-disruptive manner” as part of fine-tuning operations, said Saugata Bhattacharya, chief economist of Axis Bank.

The drawdown of surplus liquidity throughout January, aggravated by GST outflows and other factors, led overnight and short-term interest rates to breach the policy corridor, but “the squeeze is likely to be relatively temporary, with the maturing of VRRR balances, the transfer of large amounts to states as devolution, and by the likely usual increase in Centre month-end spending,” Bhattacharya said.

The situation should stabilise shortly, but till then “the market might witness some disruptions,” said Soumya Kanti Ghosh, group chief economic advisor of SBI.  “There is an impact of market microstructure on liquidity that is exogenous to policy, including asymmetric liquidity distribution amongst banks,” said Ghosh.

Rising inflation and tighter global monetary policies are putting pressure on local bond yields and the RBI may have to continue with liquidity infusion to support the economy and keep rates in check, said Arun Singh, global chief economist, Dun & Bradstreet, pointing towards the devolvement, where the RBI forced underwriters to buy Rs 2,000 crore out of Rs 6,000 crore of its five-year benchmark bond. “The RBI’s announcement is a much-needed relief. It may not be sufficient, though. Tax outflows are usually higher during the last quarter of the fiscal. The government may also tighten spending to meet fiscal deficit targets, adding to liquidity woes,” he said.