While we await – with bated breath – the outcome of Tuesday’s auction of the Reserve Bank of India’s (RBI) $5 billion rupee-dollar swap instrument, let's take a quick look at what brought this about.
The central bank calls it a long-term approach to liquidity management, not a short-term fix; the RBI actually heralded this approach way back in 2016, when it said that “the Reserve Bank intends to first meet requirements of durable liquidity, and then use its fine-tuning operations to make short term liquidity conditions consistent with the intended policy stance”.
Oddly enough, the bond market was surprised – and pleasantly so, if the remarks of several long-time bond market watchers and experts are anything to go by. Three questions come to mind, however. First, why now? Second, how much will it help liquidity? And last but not least, what will it do to the value of the rupee?
Let’s take the second question first. For context, consider three data points that have an impact on market liquidity: deposit growth, credit growth and banks’ holdings of government securities. Deposit growth in FY18 fell to its lowest rate in fifty years, just 6.7 percent. In FY19, deposit growth got better, to 9.8 percent, as of 1 March, 2019.
Credit growth – the second data point – was faster in comparison; in FY18, it was 8 percent, and 14.5 percent in the year so far (till 1 March, 2019, for which RBI data is available). Given current GDP projections – and expectations – credit growth will be over 14 percent in the next two years. According to one estimate, that requires an increase of Rs 25 lakh crore in deposits over the next two years. At present growth rates for deposits, that looks uncertain.
The third data point is the banks’ holdings of government securities. As on 1 March this year, they amount to 27.8 percent of total bank deposits. At one point, they accounted for over 30 percent of bank deposits or net demand and time liabilities or NDTL, but have been declining rapidly.
Given that banks maintain a statutory liquidity ratio of 19.25 percent of NDTL, that still leaves an excess SLR of roughly 8.55 percent. In theory, the excess SLR of 8.55 percent can be sold to raise money for lending purposes, through the RBI’s open market operations (OMO) window which is a favoured, though short-term, liquidity management tool.
Not so fast, though. There are a couple of other rules in play. That excess SLR is not really all excess. The math is a little complicated but bear with me. Of their 19.25 percent in SLR securities, banks can use 15 percent against which they can raise liquidity. Under Basel III rules, banks are also expected to maintain a liquidity coverage ratio (LCR) of 19 percent in the form of High-Quality Liquid Assets (HQLA), basically, government securities that can be sold overnight.
That means their holdings of government securities at the minimum will be 23.25 percent – 15 percent they can count out of the statutory 19.25 percent of NDTL, plus another 4 percent to make up 19 percent to meet LCR. That translates to 19.25 percent (SLR) plus 4 percent of NDTL. That means banks’ holdings as support for liquidity to help credit growth will be much smaller; for OMO operations and for new lending, they are likely to be inadequate. That’s the liquidity problem that the $5 billion swap is intended to address.
But why now? Attracting greater foreign investment inflows – including portfolio inflows – is a possible option. In October 2018, the RBI and the Securities Exchange Board of India (SEBI) proposed the Voluntary Retention Route (VRR) for foreign portfolio investors (FPI).
The VRR would provide exemptions from limits and caps for debt and equity investments, as long as FPIs commit to keeping 20 percent of their investments for a period they can agree to with SEBI and RBI. If the markets keep faith with FPIs, they become a source of dollar-based liquidity.
That said, FPI inflows tend to be lumpy and do not come in billions at a time. Their timing is unpredictable too. But markets are speculating on another possibility: the amount that ArcelorMittal will bring in to pay for its acquisition of Essar Steel is roughly $5 billion, and the transaction will close soon, perhaps before the end of this financial year. It’s the right amount, there is no lumpiness, and it comes through the banks whose debts will be repaid. This also answers the why now question (apart from the liquidity scenario).
What about currency appreciation/depreciation? This single payment will probably have no impact on the exchange rate at all. The historical pattern in exchange rate movement shows some appreciation in the first two quarters of the financial year, and some larger than usual depreciation in the fourth (January to March) quarter.
It – the payment and the swap – could also have a positive impact on FPI inflows; a stable, predictable exchange rate will give FPIs the confidence to invest. Many analysts have suggested that forward premia on the dollar swap will also be low, keeping exchange costs low for importers and others looking to buy dollars.
In the middle of this, there is a scintilla of uncertainty: how well the government’s very large borrowing program – about Rs 6.60 lakh crore will fare. The liquidity conundrum for that remains; deposit growth, or a substantial lack of pace in it – could well be an important factor in FY20 and FY21.
Some bond market observers and followers called the RBI’s move a stroke of genius. Maybe that’s a little too much. The central bank knows a little more and has a longer institutional memory. That means it just reads the tea leaves better.
(The writer is a former journalist)
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Updated Date: Mar 26, 2019 16:35:53 IST