The liquidity situation in India today is quite different from that in the past. This is due to a plethora of events contributing to the net liquidity position remaining in a deficit. There is a fundamental gap between growth in deposits and credit which reveals the net liquidity position. Add investments on the assets side and borrowings on the liabilities end, and the picture becomes clearer.
In the first half of the year, the lament was that deposits had moved over to the capital market which was a truism. Booming stock markets and higher returns made investments in equity and mutual funds attractive. And this was the time when interest rates peaked with the repo rate at 6.5 per cent. Banks could not offer higher returns on deposits without impinging on profit margins.
Another factor was lower government spending due to the election code, and there was a phenomenon of high government cash balances with the RBI. As government cash balances reside with the RBI and not commercial banks, all payments to the government led to a decline in growth in bank deposits.
The US factor
But since the US elections the new factor at play is the exchange rate. The US policy of imposing higher tariffs and cutting taxes besides taking a tough stand on immigration has led to the dollar strengthening.
This has meant two things. The first is that all currencies depreciated. The second is that FPI flows became volatile as the currency stability factor became important in their calculations as they weighed returns across markets.
Stock market returns across markets were adjusted to currency risk or the rate of depreciation. Add to this the concept of real effective exchange rate, which though a theoretical construct, came into play when weighing the differences. Hence inflation too entered the frame.
Central bank intervention became a key issue as conjectures were formed around how much the RBI will intervene. Reserves had peaked at around $705 billion in September, but are now in the range of $630-640 billion. But the conundrum is that as the RBI sells dollars, liquidity moves out of the system. This came in the way of liquidity and prompted fresh RBI action.
The liquidity framework of the RBI (introduced in 2020) involved use of only VRR (variable repo rate) and VRRR (variable reverse repo rate) auctions with the daily overnight repo being abandoned. But it has come back with a bang as it helps to fine tune liquidity in the system on a daily basis. Hence it is back to the old model of overnight repo to balance liquidity. This has ensured that the weighted average call rate is more or less under control at above the repo rate (6.25 per cent). It may be recollected that the liquidity framework also spoke of targeting the weighted average call rate (WACR) which is indicative of these balances.
However, two significant things have happened. The first is that as part of the measures to prop up liquidity, the RBI had a buy-sell swap of $5 billion which meant taking dollars from banks and then providing rupees. So far so good. But as banks sold dollars, the pressure on the rupee was felt and this meant that either the rupee had to fall or there had to be sale of dollars by RBI in the market which could negate to an extent the move of buying dollars through the swap. This has brought to the fore the fundamental issue in economics about controlling interest rates and currency. Letting the currency depreciate would have evened out liquidity and kept interest rates stable. But intervening in the forex market to get the right fix on volatility has led to liquidity issues which require fine tuning of operations— which in turn has meant daily operations in the market by the RBI.
The second is the anomaly in the system. The system is in a deficit, so RBI is providing funds on a daily basis which can cumulate to around ₹2 lakh crore once the longer tenure VRR are included, which remains outstanding till the next credit policy. But there are significant bank investments in the standing deposit facility (SDF) where banks can park surplus funds with the RBI for a return of 6 per cent. Now, interestingly the call rate is in the region of 6.30 per cent which is just above the repo rate. Banks prefer to take a lower return rather than lend in the non-collateralised market.
Interestingly the borrowers are using the tri-party repo market where the weighted average cost is less than the repo rate. This is something that the credit policy has highlighted because ideally banks could lend in the call market. However, activity has shifted to the tri-party repo market where it is cheaper to borrow against securities including the Treasury Bill.
Volatile rupee
Hence ,the current situation is amplified by a volatile rupee which is being reinforced by FPI withdrawals. This gets reflected in stock index movements. It has been noticed that the US’ policy stances, which may not pertain to India, have a cataclysmic impact on the dollar index which causes reverberations in the rupee. Any sale of dollars in the market to stabilise the rupee means that liquidity will be under pressure which brings central banking action back on the table.
How long markets will remain volatile is unclear. India would be in trade negotiations with the US which has deferred action on Mexico and Canada till early March. Imposition of tariffs can lead to a trade war; and exports everywhere would be impacted. Hence the dollar factor can get diluted once there is certainty around the trade related measures. But there will be a shift from external factors to fundamentals as trade balances will get impacted. Therefore FY26 would require all central banks to maintain a constant vigil.
The writer Chief Economist, Bank of Baroda. Views are personal