RBI shifts its focus to liquidity management

With Rs 4.8 trillion of excess funds flooding the system, the RBI today shifted its policy focus to liquidity management by raising reverse repo rate by 25 bps and slashing MSF by an equal measure.
The central bank also promised to have a more effective liquidity management tool in a new instrument called a standing deposit facility (SDF) at the earliest.
Accordingly, Reserve Bank left short-term lending rates unchanged at 6.25 percent for the third time since last October, increased the rates at which it borrows from banks (reverse repo) by 25 bps to 6 per cent and lowered the marginal standing facility (MSF) and bank rate by 25 bps to 6.50 per cent by narrowing the policy rate corridor.

MSF is RBI's lending rate for banks against government securities.
"We are in continuous dialogue with the government to institute an SDF, which is a response to the expert report (headed by him when he was the deputy governor), and also draws from best global practices and recommendation of the expert committee," Governor Urjit Patel told during the customary post-policy press meet.
Patel said liquidity management has become important now to contain inflation, which he sees faces more upside risks due to monsoon uncertainty and the impact of the Seventh Pay commission on housing allowances and the GST implementation.

He, however, said the note-ban induced excess liquidity has been continuously coming down -- from Rs 7.95 trillion in January to Rs 4.8 trillion by March-end.

The governor also blamed the poor transmission by banks for higher liquidity, saying "the MPC took note of the reduction in bank lending rates, but saw further scope in a complete reduction, including for small savings and administered rates".
Despite the active liquidity management measures, RBI Deputy Governor Viral Acharya, in-charge of the monetary policy department, said he is not sure about the excess liquidity playing any role in the recent spike in retail inflation and so, does not see any impact, going forward.
"The important thing to keep in mind is that while there is surplus liquidity in the system, it is actually getting drained out through the large quantum of variable rate reverse repos that we are doing," he said.

Patel said the measures introduced today are aimed at draining out the "remaining liquidity overhang, manage the new drivers of liquidity in fiscal 2018 and ensure the normal requirements of liquidity consistent with the needs of a growing economy are met".
The first step to achieve these objectives is narrowing of the MSF corridor to plus or minus of 25 bps, Patel said, adding that this is a continuation of reforms initiated in April 2016 when it was narrowed to 50 bps.
"The objective is to more finely align the money market rates with the policy rates, bring down volatility and create conditions for better transmission of monetary policy across the whole spectrum of interest rates," he stressed.

He also explained that when liquidity flips to a tighter mode, the cost of funds through the MSF will be lower by 25 bps, which will help borrowers.
The second step is assigning appropriate instruments to the sources of liquidity, Patel said, pointing out that "over the first half of the year, we expect government spending to increase significantly, including due to large redemptions, which will suck out a lot of funds".
Also, liquidity associated with forex inflows will be managed with securities under the MSS (market stabilisation scheme), the governor said, but admitted that budgetary provision of capping them to gross issuances of Rs 1 trillion will be an operational constraint that circumscribes the effective use of MSS as an instrument of liquidity management and increases the burden on RBI's own

instrument mix. "But we will endeavour to manage that," he made it clear.
Patel further said durable and semi-durable liquidity will be managed with a combination of longer tenure reverse repo and OMOs (open market operations), adding that fine-tuning will continue to be used to manage the daily mismatches in liquidity demand and supply.
"We will continue to provide assured liquidity through our regular operations under the LAF," Patel said.
Keeping its hawkish stance on inflation since the February policy, the Monetary Policy Committee projected retail inflation at 4.5 per cent for first half of 2017-18 and 5 per cent for the second half.

Admitting that hitting the mandated 4 per cent inflation is a challenge, Executive Director Michael Patra said "what we are signalling is that the move to 4 per cent is going to be challenging. There are no lucky disinflationary forces on the horizon that were there in the past and therefore, it is in this context that we moved the stance from accommodative to neutral in February".
"There is no one-way bets on the way RBI moves. Evolving outlook will decide how we move, but we are cautioning you that inflation is anywhere relative to where we want it to be," he added.

The RBI also increased its growth forecast and pegged the GVA-based economic expansion to 7.4 per cent in 2017-18 from 6.7 per cent last fiscal.