While officials of the Reserve Bank of India (RBI) had publicly stated that the central bank was keen on ensuring a cash deficit of Rs 50,000 crore on average in the banking system (forcing banks to borrow from RBI through the repo window), the average shortfall over the past month has been well over Rs 100,000 crore. In its keenness to rein in inflation, has RBI’s liquidity squeeze been a case of overkill? What could have contributed to this? There could be several reasons for this. For one, a one percentage point increase in the cash reserve ratio or CRR (the fraction of deposits that banks are mandated to keep with RBI) over the last two years has reduced the amounts of spare cash that banks have. In the process, the so-called money multiplier has declined and the pace of money creation in the economy has slowed. Large transactions like the 3G auction and public offers of shares by government-owned companies like Coal India Limited have transferred money from banks to the central government’s accounts with RBI. The government has been unable to spend this money fast enough to put it back in the banking system. Besides, despite large capital inflows that pushed up the rupee in September and October, RBI was reluctant to “intervene” in currency markets. Intervention by the central bank not only arrests appreciation in the currency but also helps infuse liquidity since RBI effectively absorbs dollars and releases rupees. Thus, it seems in retrospect that by deciding to stay on the sidelines, RBI missed a crucial opportunity of setting the liquidity house in order.
There are obvious risks that this cash famine engenders. Short-term deposit and lending rates have moved up sharply and unless the situation eases, lending rates across the board could start escalating. This could hurt the recovery in the investment cycle that seems to have just about got under way. RBI has tried to help matters by effectively cutting the statutory liquidity ratio (SLR) in two instalments over the last month from 25 to 23 per cent. The second instalment of a percentage point was announced on Monday. SLR is the fraction of deposits that banks have to invest in government securities. A reduction eases up the cash position of banks, leaving them with a larger proportion of deposits that they can lend to non-government borrowers. The reduction seems to have helped but only at the margin. Also it is, at best, only a temporary reprieve. A more permanent solution can either be that RBI buys dollars from the market or reduces the CRR. This is easier said than done. A cut in CRR that is geared to shoring up liquidity could give the impression that the central bank is softening its stance on inflation. RBI would want to avoid sending out these conflicting signals at a time when growth numbers seem strong and headline inflation remains high. Thus, managing liquidity well is bound to be a difficult balancing act. A couple of things seem clear though. RBI should not miss any chance of intervening in the currency market, if indeed capital inflows do pick up, and swap surplus dollars for rupees. It should also desist from hiking policy rates unless this liquidity mess is sorted.
