Temporary spike

The interest rate in the call money (overnight) market surged close to 20 per cent last week. This is the market in which banks borrow from each other or other financial players, such as mutual funds, primarily to meet mandatory cash requirements. Since the Reserve Bank of India (RBI) raised the cash reserve ratio (CRR) on December 8 by 50 basis points in two stages, there was bound to be a scramble for cash in the market as banks acted to meet the new standards in the period between the announcement and January 6, the date by which the second part of the hike became effective. However, given that banks have a couple of alternative channels to meet their cash requirements, the sharp spike in the call rate took people by surprise. With hindsight, though, the factors contributing to it are easy to identify.

The main alternative to the call money market is the repo window operated by the RBI, through which banks can borrow against collateral of government securities. In fact, for the past couple of years the RBI has used the rate on this lending channel as its primary policy instrument, last raising it by 25 basis points in its quarterly announcement on October 31. It was precisely because this measure was perceived as not being entirely effective that the RBI found it necessary to go back to the CRR, an instrument that had been considered by many to be obsolete. Higher cash requirements would put pressure on liquidity, in turn pushing banks to the repo window. However, this would work only if banks had securities to spare, against which they could borrow. Over the last few weeks, the aggregate banking system's portfolio of securities has fallen to as low as 27 per cent of deposits, barely a couple of notches higher than the minimum of 25 per cent stipulated by the statutory liquidity ratio (SLR), another policy instrument. Some banks were already at the limit. Overall, this limited the ability of banks to use the repo window.

The other source of liquidity for banks in recent times has been the large inflow of foreign exchange, as global investors expand their exposure to Indian assets. One major reason why the RBI felt compelled to resort to the CRR increase is that this inflow had increased sharply during November, neutralising the impact of the repo rate hike in October. However, since most of the developed economies effectively shut down between Christmas and New Year, investment flows during this period normally decline to a trickle. The third factor reinforcing the liquidity constraint during these last couple of weeks was the third instalment of advance tax payments, which have boosted the government's coffers but temporarily depleted the banks of cash.

Clearly, the last two factors are temporary and will return to a more normal state this week. Investment flows will resume the momentum that they showed before the year-end vacation, while the tax collections will be recycled back into the system. The call rate, therefore, has already begun to return to more reasonable levels and the spikes are a thing of the past. The only question that remains is: shouldn't the RBI have anticipated these conditions before deciding on the CRR hike? Probably, but then, no serious harm has been done.