Cash squeeze likely to prompt further rate cuts

The time for Indian companies to pay tax is near, and that could mean accentuated cash tightness which pushes up overnight interest rates and spurs the Reserve Bank of India to cut banks’ cash reserve ratio in March.

The last cut in the ratio (CRR) was in January, by 50 basis points to 5.5 percent.

Overnight interbank rates rising to close to double digits and banks dipping into a special liquidity window to borrow at higher rates for a week or two would be decisive factors that could prompt RBI to cut the CRR again, four RBI officials said.

[caption id=“attachment_219825” align=“alignleft” width=“380” caption=“The last cut in the ratio (CRR) was in January, by 50 basis points to 5.5 percent. Reuters”]  [/caption]

A CRR cut might still leave the cash deficit- the shortfall among banks to fund their loan book - above the RBI’s comfort level. However, central bank officials won’t lose sleep as long as systemic interest rates remain stable, the officials said.

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India is experiencing a bout of cash tightness that started in mid-November. The call rate has mostly remained close to the repo rate of 8.50 percent, except for a few days in January, and that’s key reason for the RBI to not step up its liquidity infusion steps.

The cash deficit is currently around Rs 1.6 lakh crore. Banks expect it to rise to Rs 2 lakh crore rupees in mid-March, with the bulk of the increase stemming from companies pulling cash from banks to make tax payments.

The RBI prefers to maintain a cash deficit position, for making monetary policy effective. It has said its comfort zone for the deficit is around Rs 60,000 crore..

Still, the current, severe credit crunch - which has kept the deficit more than double 600 billion rupees -has not made overnight rates shoot up, mainly because of the availability of funds from the RBI’s repo borrowing window, the officials said.

“The comfort zone is only an indicative one,” said a senior RBI official. “We don’t need to get unduly disturbed as long as call rates do not shoot up, government bond yields and auctions do not show signs of stress.”

The central bank keeps a close eye on the interbank overnight rate market as it considers this to correctly reflect its liquidity management stance.

Dealers expect the call rate to rise to 9.5-10.0 percent from 8.5-9.0 percent now, and banks to tap the special liquidity window, called the marginal standing facility, to deal with cash outflows for tax. If they do, this will signal stress to the RBI.

Though the overnight rates have not moved much, short-term rates on other instruments such as bulk deposits or certificates of deposit, overnight indexed swaps, Treasury bills have gone up.

The 3-month certificate of deposit rate rose to 10.20 percent from 9 percent in mid-December while the one-year swap rose by nearly 40 basis points to 8.07 percent and 3-month T-bill rate was 8.94 percent, up from 8.49 percent.

Currently, the central bank has only two options to channel primary liquidity into the system - putting more cash with banks by purchasing some of their government bond holdings through open market operations (OMO), or cutting the CRR.

“We can address the permanent shortfall through OMOs and CRR cuts. But these steps will only help in neutralising a part of the incremental shortfall in liquidity and not the entire shortfall,” said a senior RBI official.

RBI officials admit that the central bank should have anticipated the cash crunch that began in November, and started injecting liquidity before then.

Another option buying dollars in the spot market – can also help in easing the tight cash conditions. But the RBI is very clear in its exchange rate policy: it won’t use intervention in the forex market as a tool to manage liquidity.

RBI Deputy Governor Subir Gokarn said on February 8 that exchange rate volatility, and not liquidity, will be the prime driver for forex intervention.

Last month, a senior RBI official told Reuters the central bank may resort to intervention in the forwards forex market in addition to spot, so that the impact on liquidity is shifted to a later date.

The RBI has been selling dollars consistently since September to bolster a weakening currency, which added to the cash tightness.

Many factors are responsible for India’s sustained liquidity deficit. Among them are inadequate government spending, seasonal currency withdrawals by the public from banks, high reserve requirements which mean banks cannot lend out a chunk of their growing deposits and the RBI’s forex intervention to support a weak rupee.

The liquidity shortfall started to shoot well past the RBI’s comfort zone from mid-November when banks’ borrowings from the central bank under what’s called the liquidity adjustment facility (LAF) averaged one trillion rupees daily. LAF is another form of open market operations, an RBI official said.

“If there is any problem during advance tax outflows, we can take discretionary measures to address problems temporarily, as we have done before,” the official said, adding that the RBI can relax the statutory liquidity ratio (SLR) and open two LAF windows.

The official said that the central bank will decide what to do closer to the time that banks get in a bigger cash squeeze because of withdrawals for tax payments.

The RBI has maintained that it conducts open market operations only to meet liquidity objectives. Still, such auctions have helped to keep government bond yields and, to some extent, rates for overnight indexed swaps (OIS) artificially down, despite the country’s cash strain.

“There is always a price for every action. Eventually we are ending up keeping the yields subdued and that is a fallout of OMO which we have to bear,” said another RBI official.

Aside from January’s 50 basis point cut in the CRR, the central bank has moved to infuse liquidity since mid-November by buying around 906 billion rupees worth of bonds from the open market.

The 10-year benchmark government bond yield touched a one-week high of 8.27 percent on February 9 in the absence of an OMO announcement. It fell to a nine-month low of 8.10 percent on February 1, when the market was cheered by the RBI’s first debt-buy announcement since January 17.

Reuters