The recent announcements by the Reserve Bank of India (RBI) in resorting to unconventional methods in providing durable liquidity to the banking sector are most welcome and are a clear example of use of "constrained discretion" in monetary policy making, says State Bank of India (SBI).
In a report, Dr Soumya Kanti Ghosh, group chief economic adviser of SBI, says, "In the Indian context, the long term repo operations (LTRO) would clearly facilitate banks to undertake maturity transformation smoothly and seamlessly so as to augment credit flows to productive sectors as such LTRO is durable liquidity and will substitute frictional liquidity in banking system. Such LTRO will provide a clear timeline as to when money will flow but the impact on banks' costs of funds (up to 1-2 basis points / Rs1 lakh crore on a deposit base of Rs130 lakh crore) is minimal unless augmented by larger LTROs. LTRO has also no negative carry on cost of fund because of no CRR requirement."
The new dispensation in RBI post December 2018 has been going beyond text book prescription of rate cuts in addressing sectoral imbalances and declining credit growth.
RBI has conducted two LTROs for three-year and one-year tenor for Rs25,000 crore each on 17th and 24 February 2020, respectively. Additionally Rs50,000 crore worth of three-year tenor will be conducted in March. The LTROs are on a fixed-rate basis and the rate will remain fixed for the tenor of the operation. The interest will be compounded on an annual basis.
Interestingly, SBI says, even as the system liquidity surplus has been close to Rs3 lakh crore on an average, there is a misleading perception in the market domain that de-risking the financial system has brought down the growth of money supply (M3) in recent times, however, it is not correct.
"First, the creation of money supply is largely endogenous in Indian context, catering purely to low money demand. It may be noted that gross domestic product (GDP) growth has declined from 8.7% in third quarter (Q3) FY2018 to 4.7% in current quarter indicating a growth slowdown that might be still continuing with the added uncertainties of corona virus. Mirroring this, the M3 growth has declined from an average growth of 10.8% for the five year period ended FY2019 to 9.6% currently. Second, the decline in M3 growth is also because of a sharp decline in money multiplier post demonetisation."
Against this background, SBI says, the recent steps by RBI are a signalling device to the market. "First, the LTRO was used by the European Central Bank (ECB) during the European sovereign debt crisis to lend money at very low interest rates to Eurozone banks. Under the LTRO of the ECB in December 2011 and February 2012, around €1 trillion was injected. Empirical evidences suggests that the opportunity to substitute long-term central bank liquidity for short-term liquidity enhanced the transmission. It also benefited larger borrowers more and did not lead banks to increase their lending to riskier firms," it added.
As per SBI's estimate, RBI LTRO operations will bring down the cost of funds though at the margin for banks who can now borrow up to three year funds at repo rate. "However, as compared to the overall deposits of the ASCBs (Rs132 lakh crore as on 14 February 2020), this amount of Rs1 lakh crore is not even 1%, so the impact on bank's cost of funds will be miniscule, up to 1-2 bps. So, if RBI continues with these operations further then it can have some more meaningful impact on transmission".
"This move has however brought down the short-term rate significantly. Call rate declined by 10 bps during the period. The yields for G-Secs for 1-year declined by 22 bps, 3-year by 42 bps and 5-year by 29 bps since the announcement in the policy. T-bills also declined 4-12 basis on different maturities," SBI added.