By Errol D’Souza
The institutions of the state are fond of referring to ancient Indian thought in policy making. The defence minister recently launched Project Udbhav for the Indian army where it would draw on treatises such as the Arthashastra, Nitisara, and Thirukkural for lessons on strategy. The NCERT has recently stated that the Ramayana and Mahabharata should be taught as history lessons in schools. The RBI Governor has frequently been referring to Arjuna to communicate how the RBI is focused on inflation while accounting for factors that influence its achievement of the target of getting inflation to 4%. Over the last year, the RBI has raised the policy rate by a cumulative 250 bps since April 2022 to February 2023 to cool inflation and has held rates steady since.
During the pandemic, the RBI had initiated extraordinary liquidity measures that resulted in a liquidity overhang of a very large amount (about Rs 8,500 billion) in the banking system by April 2022. The RBI was confronted with how to withdraw this liquidity in a non-disruptive manner and over a multi-year time frame. The Standing Deposit Facility (SDF) was introduced at the beginning of the rate hike cycle to reduce the liquidity surplus at a level consistent with the monetary policy stance of the RBI.
The aim of the SDF was to strengthen the operating framework of monetary policy with this additional tool for absorbing liquidity without collateral and it replaced the reverse repo rate as the floor of the Liquidity Adjustment Facility corridor at 25 bps below the policy rate, symmetric to the upper end of the corridor’s Marginal Standing Facility that was 25 bps above the policy rate. In 2020, at the time of the pandemic, the width of the LAF corridor had been widened to 90 bps by asymmetric adjustments in the reverse repo rate vis-à-vis the policy rate. The RBI posited that as financial markets returned to normalcy in April 2022, the width of the corridor is best restored to its pre-pandemic level. However, the central bank has been deficient in not providing an explanation as to how it has labelled this as a symmetric corridor when the roof of the corridor which is used to inject liquidity requires banks to provide collateral and the floor of the corridor absorbs liquidity without collateral.
The SDF works towards reducing the liquidity overhang by transferring money to banks that do not lend and instead deposit it at this facility provided by the RBI. The daily absorption under the SDF averaged Rs 1,500 billion during 2022-23 and the interest paid out by the RBI over the year was Rs 74,447 million. The average interest rate paid out by the RBI on the absorption under SDF is 4.9%. This is 8.5% of the surplus (or net income) transferred by the RBI to the government in the year and 24.5% of the surplus transferred the previous year—a considerable loss of revenue to the government.
There is additionally a weakening of the transmission channel of monetary policy. By making transfers to banks in the process of liquidity absorption, the RBI is increasing the value of equity of the banks and this reduces their cost of funding bank loans, which in turn increases the incentive for banks to lend. At the same time, the RBI, to tame inflation, is increasing the interest rate—this impacts asset prices and lowers the collateral value of loans apart from making them more expensive. This makes banks reduce the supply of loans. By raising interest rates the RBI is simultaneously lowering loan supply and increasing it. This reduces the potency of the transmission channel of monetary policy.
The RBI also has been wanting in not giving an explanation as to why the SDF is claimed to be a financial stability tool in addition to its role in liquidity management. Minimum required reserve requirements are a recognised financial stability tool and, since the onset of the pandemic, the CRR was cut to release around Rs 1,370 billion of liquidity in the markets. The RBI also provided exemptions from CRR maintenance for incremental loans for residential housing and MSMEs. Surprisingly, the RBI, since April 2022, has been raising the CRR outside the MPC meetings and it has been non-transparent as to why a monetary policy tool is not in the remit of the Monetary Policy Committee (MPC) that should be involved in such decisions. Raising minimum reserve requirements is arguably more powerful in restricting excessive credit and inflation when there is a liquidity overhang in the system.
Arjuna punished himself with a twelve-year exile and took an oath of celibacy for having disturbed Yudhishthir and Draupadi. But, soon after going into exile, he allowed himself to be seduced by Ulupi, and broke his vow twice more by marrying Chitrangada and Subhadra. The breach of the vow on one interpretation is why he was required by Yama to spend a short period in hell. In a symbolic corollary, the RBI gets its monopoly power over the creation of currency from the central government and so any surplus it earns from that should be handed over on behalf of taxpayers to the government and not paid out to commercial banks. The use of CRR as a tool of countercyclical policy is not as old as ancient Indian thought and should be deployed in the face of the excess liquidity rather than using the modern SDF. The RBI should, as part of its communications, elucidate how the SDF is a better financial stability tool, why the MPC is not deciding on the CRR, in what sense the LAF corridor has been restored and when will the SDF be replaced by the reverse repo rate, and how it envisages the transmission channel of monetary policy with the SDF as part of the policy toolkit. Until it does that, Arjuna requires assistance from a Shikhandi shield, to successfully hit the target from behind this.
The author is Professor of Economics at IIM Ahmedabad.
Views are personal
