The past six months of COVID-19 has seen the Reserve Bank of India (RBI) go into an overdrive on account of its misplaced belief that a public health emergency demands an emphatic “Whatever It Takes” response. It appears to suggest that reducing interest rates and supplying liquidity to the banks will mitigate the economic consequences of a public health emergency. The actions of the apex bank are intended to incentivise borrowings by banks in order to support more borrowings by households, small and large corporate businesses.
Whilst these actions appear to be timely and laudable, they shift the onus of action away from the union government to RBI.
The public health emergency on account of Covid19 is a crisis, which has resulted in large income loss on account of cessation or moderation of economic activity. This demands timely and decisive government action to mitigate the loss of income and the impairment of businesses which is emblematic of a solvency problem. A solvency problem demands direct and indirect fiscal intervention of the government.
The government action has been tentative, the argument being that government cannot do “Whatever It Takes” in a public health emergency because it lacks resources or fiscal space. A direct consequence of this has been demands on the RBI to do “Whatever It Takes”. The demands for monetary policy action when fiscal policy is almost absent have been shrill, insistent and keep increasing. RBI clearly has succumbed to pressure.
The impact of this pressure is visible in the operations of the most important segment of the financial market, the money and debt markets. The consequences to macro-economic and financial stability of the hurried actions of RBI can be far-reaching.
RBI's liquidity adjustment facility (LAF), which it has refined and tweaked over the years, is the most sophisticated liquidity management mechanism in the world. LAF enables RBI to inject and drain inter-bank systemic liquidity. LAF works as a rate corridor, with the repo rate as the rate at which liquidity is supplied to banks. The reverse repo rate is the rate at which liquidity, which is in excess, is drained. There is a spread between the repo rate and the reverse repo rate, which determines the width of the LAF corridor. This has generally been 1% till the RBI governor arbitrarily reduced it to 0.65% (or 65 basis points-bps). There have been discussions in the past to narrow this corridor to O.50% with a suggestion to reduce this in 0.25% instalments.
Our out-of-box thinking present governor believes that there is nothing sacrosanct in the 25bps increments. So, this spread was reduced by 35bps to 65bps as mentioned above. A key point to underline is that the operating policy rate is the repo rate. RBI, before and after Monetary Policy Committee (MPC) started functioning, changed the repo rate to announce its interest rate decisions. As an operating policy rate, the repo rate sets the term structure of the short-term money market rates by targeting the overnight interbank rate (also called call money), the intent being to maintain the overnight interbank rate around the repo rate. This outcome is achieved by RBI through a combination of fixed-rate repo, variable-rate overnight repo, variable-rate term repo and reverse repo operations as part of LAF. During periods of liquidity deficit, it is easy to maintain the overnight or call interbank rate at and around the operating policy repo rate by enabling banks to borrow at the repo rate.
This understanding is intrinsic to understanding the extent of interest rate policy intervention from the MPC.
All stakeholders in the financial markets, assess the quantum of rate cuts on the basis of the quantum of reduction in the repo rate. However, the situation gets muddy during extended periods of surplus or abundant interbank liquidity as we have witnessed over the past six months. RBI has acted to engender this excess interbank liquidity. During such a period, RBI is absorbing this excess liquidity. This liquidity gets drained at the reverse repo rate. In line, the overnight or call money rate settles around the reverse repo rate and the term structure of money market rates now shifts downwards to align with the reverse repo rate. Unless...
Unless, RBI does variable rate reverse repo operations where the cut-off rate is closer to the operating policy rate, the repo rate. RBI did do this in the past when its intent was very clear to maintain the overnight or call money rate around the repo rate. When RBI's intent changes, and it is desirous of doing disproportionately large rate cuts outside the MPC framework, it just absorbs the liquidity at the reverse repo rate. So, the total quantum of rate cut is now an additional 65bps (the difference between the repo rate and reverse repo rate).
The limit on RBI's ability to absorb liquidity at the reverse repo rate is set by the size of its holdings of government securities (G-Secs), which it offers as collateral as part of the collateralised borrowing (absorption) reverse repo operations. During the current liquidity deluge, this limit has not been tested as the quantum absorbed by RBI is less than its available holdings of G-Secs.
The implication of this is that the residual excess liquidity changes hand in the interbank collateralised borrowing and lending market at lower than the reverse repo rate.
In the recent past, the interbank market rate has been close to 3%. Therefore, the effective rate cut delivered is 1% and more than the cumulative repo rate reduction. For instance, on 25th November, the total amount transacted in the overnight call and market repo market was Rs3.36 lakh crore—at a weighted average rate of 2.68%.
We are already in an over-the-top monetary accommodation of an additional 125bps over and above the cumulative repo rate cut delivered by the MPC.
One is puzzled that the MPC members and MPC cheerleader (Ashima Goyal) doesn't see this in-your-face monetary accommodation that has happened. MPC members merely twitter about more scope for monetary accommodation opening up when CPI (consumer price index) inflation eases in Q4FY20-21. Amazing wilful blindness.
Now to address the issue of paucity of collateral for liquidity absorption. This can be easily handled and has been extensively debated in the past. This is the special deposit facility (SDF). The SDF in a situation of excess liquidity is easily actionable. It is banks, who are placing an unsecured deposit with RBI. RBI being co-terminus with the sovereign most banks should not have a counterparty exposure limit issue for placing unsecured or clean funds under SDF.
The core issue is what should be the SDF rate. Common understanding would suggest that the unsecured placement rate should be higher than the collateralised placement rate. Therefore, the suggestion that this rate be above the current reverse repo rate (3.35%) at, say, 3.50%.
In the past, when this issue was debated a large section of the fixed-income traders were of the view that the SDF rate should be 50bps-100bps lower than the reverse repo rate. The intent behind this suggestion was not a benign desire to restore growth through deep and aggressive effective interest rate cuts but more mundane and transactional. Bonds would rally. Such is the mindset of the fixed income traders.
The auction cut-off yield for 91 days treasury bills on the 25 November 2020 was 2.93%. What we are seeing is an inverted short end of the overnight and treasury bills yield curve. RBI has today engineered a complete collapse of the term structure of the short-term money market. This is on account of the RBI governor undermining and short circuiting the LAF structure in which the repo rate is both the de-jure and de-facto operating policy rate.
This collapse has serious consequences as it has transmitted fastest to the savers through a sharp reduction of bank fixed deposit (FD) rates. Average FD rate for a one-year, one-day fixed deposit is 5%. Ex-post CPI inflation is close to 7.5% and ex-ante CPI inflation forecast at around 5%. The inflation adjusted return of bank FD is negative and expected to stay negative in the near future. Bank FDs are a large and important constituent of household financial savings, especially the retired, who live off retirement savings held principally in bank FDs.
The MPC slavishly believes that encouraging borrowings, especially retail borrowings for consumption through sharp rate reductions will restore growth and economic activity. It summarily disregards the need to compensate bank FD holders fairly.
Surely, we all agree that stable and growing domestic savings, which are available to finance investments, are the key to Atmanirbharta. Imported foreign savings, do not enable but undermine Atmanirbharta. It is very perplexing to see a distinct MPC preference for imported savings over domestic savings. The MPC keeps talking about supply side inflation to justify and provide intellectual cover to cut rates and cut them more. By design the focus is always on the borrowers never on FD savings.
We are witnessing around us an undermining of institutional structures and weakening and elimination of checks & balances. RBI too is at the vanguard of the trend. Led by a governor who has exceeded his brief and got carried away by “Whatever It Takes” zealousness.
I am not getting into the issues of interventions in the FX market and the adequacy of FX reserves as well as the instruments other than LAF to drain the enduring excess liquidity, like market stabilisation scheme (MSS) and how this would conflict with attempts at yield curve control (YCC) through outright OMOs and operation twist.
The few showing truth to power like Raghuram Rajan, Viral Acharya and Urijit Patel get continuously trolled by those who consider this 'negative thinking'. All these were stellar RBI officers who have competently and with courage served RBI in the past. RBI needs to ponder and course correct soon.
(Rajendra Gill is presently a whole-time director with VMS Consultants Pvt Ltd an expertise-based design consulting practice. Mr Gill has worked in the financial markets for more than two decades. He is an ex-officer of TAS (Tata Administrative Service).)