While the debate on whether or not the Reserve Bank of India (RBI) should hike interest rates immediately in response to still high inflation rages on, the short-term benchmark rate for banks has effectively moved up by a hefty one-and-half percentage point over the last three weeks. A severe liquidity squeeze in the banking system since the end of May has meant that banks are no longer parking with RBI huge surpluses that fetched a return of 3.75 per cent at the “reverse repo” window. They are, instead, borrowing massive amounts from RBI at the repo (repurchase) window, paying interest on these overnight loans equal to the repo rate of 5.25 per cent. Reverse repo and repo rates are the so-called “policy” rates that RBI sets periodically to influence all lending and borrowing rates in the economy. Which of these two policy rates is the effective short-term benchmark depends on whether banks on average are cash surplus or deficit. A shift from surplus to shortage for the banking system (as has happened from end May) means that the repo rate replaces the reverse repo as the effective policy rate. In short, it is a de facto increase in the policy rate by one-and-half percentage points. For those bewildered by RBI’s apparent insensitivity to high inflation, this might explain why the central bank seems reluctant to hike the policy rate immediately. If the benchmark rate has indeed gone up by as much as one-and-half percentage points, it perhaps makes sense for RBI to wait for the shortage to dissipate before announcing a more explicit hike in rates.
This liquidity crunch for banks has emerged because the government, somewhat ironically, has an embarrassment of riches. The 3G spectrum auction fetched double of what was budgeted. Add to this another Rs 40,000 crore that is likely to come from wireless broadband auctions and the government is in a situation where it has more cash than it can hope to spend immediately. There lies the rub. When the government collects money from, say, taxes or spectrum auctions, the money leaves the banking system and moves to the government’s account with RBI. This reduces the cash or the “liquidity” levels available with banks. Currently, the combination of advance tax outflows and the 3G outflows means that banks are short by roughly Rs 60,000 crore, and this is likely to get worse. Liquidity can be restored with banks only when the government spends the money it has collected and, in the process, funds get transferred back from the government’s RBI account to the banks. Government spending follows a cycle set firmly in place with many layers of red tape. While its reputation for spending might be prodigious in the long term, its ability to step up spending quickly is limited. RBI is doing its best to offer short-term relief — it has increased the limit on banks’ borrowing from the central bank. It has also persuaded the government to buy back some of its existing bonds, a simple transaction in which banks get ready cash by selling bonds to the government. While this could help at the margin, it is unlikely to plug the liquidity hole entirely and the cash crunch could persist until the end of July if market analysts are to be believed. How big a hole there is ultimately depends on the government’s ability to step up spending. One option is to perhaps pay the oil companies their dues over the next few weeks by getting quick parliamentary approval. Finance ministry boffins need to think of other ways of replenishing liquidity quickly. Otherwise the government’s windfall could, in a stroke of irony, push lending and borrowing rates up.
