Money is going to get tighter as we enter the festive season

The Reserve Bank of India (RBI) will have to think out of the box to ease an expected liquidity tightening situation. Banking system liquidity is expected to worsen going forward on the back of a rising trade deficit, muted capital flows and a weakening rupee.

The second half of the fiscal year is also the busy season due to harvests and festivals. Credit demand will pick up and banks starved of liquidity will have to raise rates to borrowers to fund credit. Banks will have to borrow heavily from the RBI in the repo window to maintain daily liquidity requirements.

Banks borrowed Rs 70,000 crore on a daily average basis last week, up from Rs 17,000 crore seen in the week before last. Advance tax outflows of over Rs 45,000 crore impacted liquidity but given that the government is maintaining an overdraft with the RBI of around Rs 28,600 crore, the advance tax will go towards paying off the overdraft rather than coming back into the system.

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Maturity of cash management bills worth Rs 14,000 crore will come back into the system but this will not be enough to ease the pressure on liquidity.

[caption id=“attachment_88086” align=“alignleft” width=“380” caption=“Banks borrowed Rs 70,000 crore on a daily average basis last week. Reuters”]  [/caption]

The sharp jump in the trade deficit during the April-July 2011 period is liquidity negative. The trade deficit stood at US$ 54.9 billion in the April-July period against US$ 47.8 billion in the same period last year, a year-on-year rise of almost 15 percent.

A rise in trade deficit leads to an outgo of US dollars from the system. If the trade deficit is not bridged by capital flows from abroad it leads to a negative impact on the Indian rupee (INR).

Capital flows this year are down sharply from last year with net foreign institutional investor (FII) purchases of equity and debt for the January- August 2011 at Rs 18,000 crore against Rs 1,02,000 crore seen last year.

The INR has depreciated by 8 percent against the US dollar in the last month-and-a-half on the back of a rising trade deficit, weak capital flows and global risk aversion. Worries on Greece defaulting on debt and a downgrade of the credit rating of Portugal and Italy has led to investors selling emerging market currencies, including the INR.

The RBI last year faced a liquidity crunch with banks accessing the repo window for funds for amounts of over Rs 1,40,000 crore on a daily basis. The crunch was largely due to the government maintaining a surplus balance with the RBI of amounts of over Rs 70,000 crore.

The RBI, in order to ease liquidity, embarked on a government bond purchase programme of Rs 65,000 crore in the November 2010 to January 2011 period.

The bond purchase added primary liquidity in the system but did little to inflation, which was on an upward trend. Inflation, as measured by the WPI (Wholesale Price Index) was trending at around 8 percent levels in December 2010 after which it picked up pace to trend at over 9 percent levels.

The RBI will have to do serious liquidity management this year. If liquidity tightens sharply and banks are forced to come to the RBI for funds, the central bank will have to use tools to ease liquidity.

Bond purchase is not a solution as it adds to inflationary expectations and the RBI has been raising rates consistently for the last 13 months to quell inflation expectations. Inflation printed at 9.78 percent for the month of August, prompting the RBI to raise rates in its September policy review.

The RBI can use the LAF (liquidity adjustment facility) window for easing liquidity rather than resorting the inflationary tool of bond purchases. If liquidity tightens considerably, the RBI can lend longer term funds under repo to ease liquidity.

RBI can also allow banks to borrow under the MAS (marginal standing facility) for longer periods of time. The cost of borrowing in the system will go up but it will act as a quasi rate hike and the RBI need not raise rates further to bring down inflation expectations.

A CRR (cash reserve ratio) cut is also an option as there is scope to bring down CRR from 6 percent levels. A 1 percent cut of CRR will add Rs 50,000 crore to the system.

Anything but bond buybacks!

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.