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RBI takes a first step towards normalisation: Resumes variable rate reverse repo auctions

RBI announced its intention to restart variable rate reverse repo auctions, as a first step towards policy normalisation. With economic activity rebounding, steps to gradually drain excess liquidity were expected in 2021, but the exact timing was not clear.

While we expect RBI to roll back excess liquidity through 2021 in a gradual and non-disruptive manner, we do not expect it to tinker with the policy repo rate over the foreseeable future

By Pranjul Bhandari & Aayushi Chaudhary

On January 8, the Reserve Bank of India (RBI) announced its intention to “restore normal liquidity management operations in a phased manner.” It announced the resumption of variable rate reverse repo auctions, the first of which will be held on January 15, for an amount of Rs 2 trillion, and a tenor of 14 days.

Recall that over the pandemic period, the central bank had taken several steps to infuse liquidity, cut policy rates and eased regulatory norms. The latest announcement comes as a first step towards normalisation.

What does it imply?

We believe there are two implications of this step. One, as banks park surplus funds with RBI at close to the reverse repo rate of 3.35% for longer periods, the incentive to lend at lower rates could diminish. Two, the commentary on restoring normal liquidity could work more broadly as a signal from RBI that it is ready to gradually exit from very loose policy even as it holds on to its accommodative stance. Both of these could nudge short-term rates higher.

Having said that, this remains a gentle step. It only directly impacts those financial entities such as commercial banks which have access to RBI’s reverse repo window. It leaves out other entities like mutual funds, which may continue to function at lower rates.

Was it expected?

While the timing was hard to predict, we were expecting RBI to steer on a normalisation path in 2021 for three reasons:

One, growth has rebounded strongly with new Covid-19 cases falling rapidly despite rising mobility.

Two, while CPI inflation may inch lower in December (c5% versus 6.9% last month), it could go back up to over 5.5% by March, led by rising commodity prices, a reversal in the favourable base, and a likely rise in services inflation. As such, inflationary pressures cannot be ignored.

Three, led by surplus liquidity in the system, several short-term rates such as the overnight call money rate and the 3-month T-Bill rate were trending below the reverse repo rate. The case for realigning them was strengthening.

What next?

The market reaction to these steps could help RBI test waters, as it guides short-term rates towards the reverse repo rate and over time closer to the repo rate. Some of the roll-back in surplus liquidity is also expected to happen automatically, as the one-year cut in the cash reserve ratio (CRR) reverses in April. As such, the direction is clear, although we believe RBI will endeavour to make it gradual and non-disruptive.

We expect RBI to raise the reverse repo rate in the second half of 2021 in a bid to narrow the policy rate corridor (the corridor is 65bps wide at present, versus 25bps in early 2020). However, we do not expect any hikes in the benchmark policy repo rate (currently at 4%) in the foreseeable future.

Bhandari is chief economist, India, and Chaudhary is economist, HSBC Securities and Capital Markets (India) Private Limited

(Excerpted from ‘Economics-Data Reactions: India’s RBI takes a first step towards normalization’ dated January 11, 2021, by HSBC Global Research)

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