Managing QE rollback the Indian way

By: |
January 28, 2021 6:35 AM

RBI’s calibrated measures will likely be able to address the issue of an increase in demand for funds from both the govt and the private sector in FY22

The defining features of the so-called QE, which came with a combination of instruments, are provided in the accompanying graphic; the QE had started even before the pandemic had set in.The defining features of the so-called QE, which came with a combination of instruments, are provided in the accompanying graphic; the QE had started even before the pandemic had set in.

One of the main challenges of unwinding a policy that entails a large amount of money, for any central bank, is to do this without causing disruptions to, or rather upheavals in, the market. After all, a sudden gush of money into the system can be hard to take out, and often, there are unintended consequences. For example, the QE measures of the Fed or ECB were meant to revive their economies, but the money flowed to the emerging markets. This created different challenges as the central banks had to manage capital flows as stock markets boomed. Any move to rollback caused upheaval in the market, which came to be known as taper tantrums, as it was assumed that the QE would last forever.

RBI brought in QE of a different variety ever since the lockdown was announced, but has gradually started rolling back this liquidity. This has been remarkable as it has been done in an unobtrusive way and a calibrated manner so as to not upset the applecart. But the market for sure is guessing the next steps of RBI, with there being several subjective interpretations of every new monetary measure.

The defining features of the so-called QE, which came with a combination of instruments, are provided in the accompanying graphic; the QE had started even before the pandemic had set in.

A sum of Rs 6.27 lakh crore was released into the system during the year, which is quite substantial. But there was an unintended consequence. This surplus tended to get reinvested in the overnight reverse repo operations, with the system being in a surplus-liquidity state all through this period. Ideally, the money should have been used for lending purposes, as was the aim of such measures.

On the commercial banking front, too, there was a very comfortable liquidity position (defined as the difference between incremental deposits and credit). Over March-end 2020–January 1, 2021, bank deposits increased by Rs 11.59 lakh crore, while bank credit rose by Rs 3.34 lakh crore. There was a distinct risk-aversion on the part of banks as well as a lower demand for credit, especially for investment purposes, from corporates; this gave banks a surplus of Rs 8.2 lakh crore.

The government borrowing, by both the Centre and the states, was much higher this year, but did not create any problem on the liquidity front due to this surplus generated by the banking system coupled with RBI measures. Consolidated bank balance sheet shows that, during this period, investments increased by Rs 7.34 lakh crore, and hence there was a surplus of Rs 86,000 crore after adjusting for credit and government borrowing.

Hence, RBI measures, while providing comfort to the market, have not mattered from the point of view of the availability of funds. But they did work well to lower the interest rates. This was also the idea of RBI, which used cuts in the repo and reverse repo rate both, along with flooding the system with liquidity, to keep the interest rates low. As can be expected, with the government being a more aggressive borrower in the market, the lower interest rates came as a blessing. On aggregate borrowings of Rs 12 lakh crore this year, the drop in interest rates of around 80 bps would have saved an interest cost of around Rs 9,600 crore. The extent to which rates have moved down can be seen in the accompanying graphic, which also raises some questions at the two ends of the tenures.

As can be seen, the yields at the lower end of the maturity have come down at a sharper rate than those at the higher end. This can be attributed to two reasons. First, the longer-term yields have been relatively more stable, with the decline being less than proportional to the repo rate because of the high borrowing programme of the government. The programme has been under several layers of pressure, starting with the pandemic and followed by the GST controversy with the states that kept the market guessing if there would be an excess supply of paper, which depressed prices and pushed up yields.

The second reason is that the surplus liquidity in the system, which showed in the high daily reverse repo window, led to rates coming down sharply. The call rate is now in the 3.1-3.2% range while ideally, it should be closer to the repo rate. However, the lower reverse repo of 3.35% has served as the benchmark for this market, and by induction, the T-bills yields too.

RBI has given signals of drawing out this surplus liquidity. The first move came with the announcement of the LTROs being reversed by banks, and out of the Rs 1.25 lakh crore of funds supplied, Rs 1.23 lakh crore has been reversed by banks at present. The next step was for TLTROs, where around Rs 37,000 crore has been reversed. The smaller quantum under special liquidity for NBFCs is now fully reversed. Therefore, a large section of the funds that were induced into the system are being rolled back.

The CRR cut would get automatically reversed from April onwards unless RBI chooses to keep it at a lower level. More recently, the long-term auction of 15 days at the reverse-repo window witnessed Rs 2 lakh crore being taken out, though it would flow back once it matures. Hence, there does appear to be a plan to move away, albeit gradually and cautiously from the surplus liquidity situation that is there.

There are two issues which would be important when it comes to reversing all these measures. The first is that any recovery in the economic prospects of the country will lead to demand for funds, which has to be satisfied. For Q4, there is an expectation that growth will turn positive, and there can be a turnaround in bank credit from manufacturing and services. This will require backing from the banking system.

The second is that the Budget will indicate the borrowing to be made next year and the rollover of this surplus liquidity into FY22 will be useful if this materialises. Hence, it does appear that RBI is going slow with the reversal process, and the calibrated approach will address the issue of an increase in demand for funds both towards the end of March as well as next year when the requirements of both the government and private sector will increase. There may just be the need to persevere with the existing measures.

Chief Economist, CARE Ratings and author of Hits & Misses: the Indian Banking Story
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