The banking system is evidently experiencing abundant liquidity, thanks to the government’s decision to demonetise old currency notes of high denominations and swap them with new ones. While ordinary people struggle for cash, banks are flooded with money because deposits have swelled. According to Crisil, between November 8 and 25, funds parked by banks with the Reserve Bank of India (RBI) under the reverse repo facility surged 10 times to Rs 1.5 lakh crore. As a result, by Friday, the 10-year government security yield had fallen below the repo rate of 6.25 per cent — the 10-year benchmark 6.97 per cent gilt yield has been in a free fall since the demonetisation announcement. This has not only inverted the yield curve – with the longer yield lower than the shorter one – but also narrowed the differential between Indian gilts and the US treasuries which, in turn, resulted in $2.4 billion of net foreign institutional investor funds flowing out. This led to a sharp depreciation in the rupee and has made it difficult for the RBI to cut the repo rate in the upcoming monetary policy review on December 7. But while all these difficulties facing the RBI are understandable, its response to these deserves criticism.
On November 26, the RBI surprised banks by introducing an incremental cash reserve ratio – the portion of deposits banks are required to park with the RBI – of 100 per cent on the increase in net demand and time liabilities between September 16 and November 11. The guidelines also stipulated that although this was a temporary measure, it would stay until December 9 before it was reviewed. It is estimated that this move will soak up Rs 3.5 lakh crore from the banking system. But there are many reasons why this decision has unfairly targeted banks. For one, the CRR requirement is being applied with retrospective effect, which is never a good idea. Moreover, there was no justification provided for why those particular dates were chosen. Worse still, instead of paying the stipulated four per cent interest to banks, the RBI will not be paying any interest on these deposits.
Unsurprisingly, this will hit the bottom lines of banks at a time when their profits have been under tremendous pressure due to increased provisioning for non-performing assets. Arundhati Bhattacharya, the chairman of the State Bank of India, made banks’ discomfort with the RBI decision clear by stating they needed to be compensated. Banks argue that instead of using such a blunt policy instrument, the RBI could have used alternative measures such as cash management bills issued by the government and securities issued under the market stabilisation scheme, though the RBI has said it will review its decision once the government issues an adequate quantum of MSS bonds to soak up liquidity.
While the CRR increase will lead to tighter liquidity and gilt yields moving up, neither of these positions is sustainable. That is because with each passing day more deposits are expected to come in, and with credit demand remaining low, gilt yields will fall. In the process, even monetary transmission will take a hit because banks might delay lowering lending rates, given that while they are expected to pay at least four per cent interest on deposits, they do not earn any on the deposits impounded by the RBI as CRR.
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