Why RBI stuck to its guns on liquidity

The two main VRR operations injected Rs 4.25 trillion into the banking system. (Reuters)

In its latest monetary policy, the Reserve Bank of India (RBI) has said that it will deploy an appropriate mix of instruments to modulate both frictional and durable liquidity. The liquidity conditions are driven by exogenous factors which RBI hopes to correct through market operations, explains Ajay Ramanathan

l  Extent of liquidity in the banking system

After remaining in surplus during April-August 2023, system level liquidity slipped into deficit in September after a gap of four and half years. It widened to Rs 1.6 trillion in December-January from an average of Rs 42,000 crore during September-November. As of February 8, liquidity in the banking system is estimated to be in the deficit of Rs 1.96 trillion. However, the potential liquidity in the banking system is still in surplus when adjusted for cash balances.

In his statement, RBI governor Shaktikanta Das noted that the financial market segments have adjusted to the evolving liquidity conditions in varying degrees. While the short-term rates have fluctuated, long-term rates have remained relatively stable, reflecting better anchoring of inflation expectations. Das said that the reversal of liquidity facilities under both standing deposit facility and marginal standing facility during weekends and holidays has facilitated better funds management by the banks.

l  Measures taken by the RBI to manage liquidity

During December-January, the RBI pro-actively injected liquidity through both the main and the fine-tuning repo operations to ease liquidity tightness in the system. Between December 15, 2023 and January 31, 2024, nine fine tuning variable rate repo (VRR) operations with a maturity of 1-7 days were conducted amounting to Rs 7.75 trillion. The two main VRR operations injected Rs 4.25 trillion into the banking system.

With government spending picking up and augmenting system level liquidity, the RBI conducted two four-day variable rate reverse repo (VRRR) auctions of Rs 50,000 crore each on February 2 and February 5, 2024, respectively.

Additionally, two 1-day VRRR auctions of Rs 75,000 crore and Rs 50,000 crore were conducted on February 6. The central bank also conducted two 1-day VRRR auctions of `50,000 crore each on February 7. Against a total notified amount of Rs 3.25 trillion, the RBI absorbed Rs 1.5 trillion through these auctions.

l  What RBI can do to manage liquidity

Contrary to expectations, the central bank did not announce any changes to its management of system liquidity. It contends that prevailing liquidity conditions are being driven by exogenous factors, which will likely be corrected in the foreseeable future.

At a press conference following the monetary policy, the RBI governor highlighted that the main objective of the central bank is to keep the weighted average call rate(WACR) around the repo rate. Das noted that the central bank will remain nimble and flexible in its liquidity management through two-way main and fine-tuning operations, in both repo and reverse repo.

It will deploy an appropriate mix of instruments to modulate both frictional and durable liquidity so as to ensure that money market interest rates evolve in an orderly manner and financial stability is maintained.

The instruments of control will depend on the prevailing situation that comes up from time to time. But, banks and markets will take time to adjust to the evolving liquidity situation.

l  Likely liquidity situation in coming months

Going ahead, THE central bank will likely utilise variable rate repo and reverse repo auctions as the preferred tools for liquidity management. While liquidity deficits could improve over the coming weeks, economists note that the rise in currency in circulation ahead of the general elections and advance tax outflow will keep liquidity condition tight over the coming months. This would also align with the RBI’s intention of improving transmission. Hence, WACR is seen averaging higher than or near to the repo rate going ahead.

Broadly, the central bank’s monetary policy statement has left little wiggle room for a policy pivot as the focus remains on the need to bring inflation down to 4% and improve transmission of past rate hikes.

While repo rates will likely be kept on hold for some time, the central bank may shift its policy stance to “neutral” in the June quarter of 2024-25.

This may signal a durable convergence between overnight interbank rate and the RBI’s repo rate. Following this, the central bank may begin cutting rates in the second half of FY 2024-25.