RBI’s Liquidity-Withdrawal Proposal Could Pose Risk To | Sidnaz Blog

RBI has said it will ensure ample liquidity in the banking system for lending to productive sectors.

India’s central bank, the Reserve Bank of India (RBI), signalling it plans to drain some of the massive liquidity it has pumped into the banking system, faces a challenge if it wants to avoid disrupting the government’s borrowing programme, market players say.

The government is expected to lay out a hefty borrowing plan in a February 1 budget outline for the fiscal year from April, aimed at reviving an economy that has shrunk dramatically from the impact of Covid-19, squeezing tax revenues.

This will complicate the RBI’s task in drawing down the huge surplus of cash it pumped into the financial system to boost retail lending at the height of the pandemic, economists say.

“The authorities walk a tightrope in incremental efforts to pare the extent of the liquidity surplus yet minimise reaction in (pushing up) borrowing costs as the overall policy bias remains accommodative,” said Radhika Rao, an economist with DBS Bank.

The RBI’s problem was evident last week when it drained liquidity with a 14-day variable rate reverse repo auction, only to spook the market and drive up yields across the curve, forcing the bank to reverse course with an open market purchase of bonds to calm investors.

“The RBI is well aware of the economic situation and won’t rush to reverse the high level of liquidity in the system,” said a person familiar with RBI thinking. “But measures taken last year were due to the exceptional conditions prevailing then, and it is only prudent to prepare and gradually restore things back to normal.”

The RBI has repeatedly said it will ensure ample liquidity in the banking system for lending to productive sectors, and to ensure the government’s borrowing programme goes through smoothly, which will require keeping yields in check.

The central bank said it was now looking to restore normal liquidity operations and announced the 14-day reverse repo while saying at the same time it would ensure ample liquidity as needed. The mixed messages confused the market, causing yields to spike.

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Analysts later determined the RBI was only seeking to address liquidity imbalances not tighten the cash supply.

They think it will be months before the RBI can substantially reduce the average daily surplus of Rs 6 lakh crore ($8 billion) that banks park with the RBI.

But the unexpectedly high cut-off yield set at the 14-day reverse repo auction raised worries that the RBI may eventually raise the reverse repo rate. Traders said RBI should set lower cut-offs at rollover auctions to allay these fears.

“They should continue to roll over these 14-day reverse repos,” said Bekxy Kuriakose, head of fixed income at Principal Asset Management. “It has helped anchor the overnight rates close to the reverse repo.”

The market consensus is that the RBI will need to continue supporting the market through “twist” operations — simultaneously buying and selling bonds — and outright bond purchases to avoid a spike in long-end yields and help banks absorb the fresh debt supply from the government.

“Actions are needed to communicate that there will not be liquidity or financial tightening,” said Madhavi Arora, economist at Emkay Global Financial Services. “We are still far from that state, which is neither optimal nor desirable at the current juncture.”


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