VIEW: RBI, liquidity and inflation

On Friday, RBI announced that it would restore normal liquidity operations in a phased manner while ensuring ample liquidity in the system.

Since March 2020, we have seen consistent banking liquidity surpluses of over Rs 6 lakh crore. What should be the way forward for liquidity?

‘Banking liquidity surpluses’ are funds held by banks with the RBI, in excess of their Cash Reserve Ratio (CRR) requirements. These surpluses arise when RBI reduces statutory CRR requirements, or when it purchases bonds or foreign currency from banks, or when currency is deposited with banks (see here).

Banking liquidity surpluses are not directly available for consumption or asset purchases. However, persistent surpluses goad banks to lend more and reduce short-term interest rates. Bank lending in turn increases ‘M3’ money supply – the sum of currency in circulation and deposits in banks - the money available to spur economic activity.

Besides bank credit to the commercial sector, net foreign currency inflows and bank credit to the government also increases M3.

In the fiscal year 2020-21 (FY21) till mid-December, bank credit to the commercial sector grew by just Rs 1.7 lakh crore (1.5 percent year-on-year). In contrast, net bank lending to the government increased by Rs 6.8 lakh crore (13.6 percent year-on-year) and banking foreign exchange assets increased by Rs 7.1 lakh crores (18.7 percent year-on-year).

Adjusted for the increase in banking equity and reserves, overall, India’s M3 money supply grew by Rs 12.6 lakh crore (12.4 percent year-on-year).

In summary, growth in bank credit to the commercial sector accounts for a very small part of the M3 growth in FY21. Instead, bank lending to the government and foreign currency inflows account for practically all M3 growth.

Large M3 growth can lead to too much money chasing too few goods. Given India’s underemployment, any persistent inflation is a sad reflection of our inability to produce adequate domestic output and jobs. However, for now, let us assume that M3 growth needs to be curtailed to curb monetary inflation.

Traditional theory suggests that we could adjust central bank reserve money M0 - the sum of currency in circulation and commercial bank balances with the central bank – to control M3. It suggests that the ‘money multiplier’ – the M3 to M0 ratio - stays within a range, and so reducing effective M0 (via lower banking liquidity surpluses) should reduce M3.

However, there are severe criticisms of this theory (see this Bank of England explainer, Martin Wolf FT article, and this). Beyond this debate, let us consider how banking liquidity might impact M3 in the current context.

As discussed, sustained banking liquidity surpluses goad banks to lend more, pushing down short-term interest rates.

To that extent, withdrawal of banking liquidity surpluses can slow credit and hence M3 growth. However, as argued earlier, bank lending to the commercial sector is hardly the reason behind M3 growth in FY21. Bank credit growth is still anemic, burdened by pockets of inability and unwillingness to lend.

The withdrawal of banking liquidity would also not impact bank lending to the government. The size and funding of fiscal deficits is hardly dictated by interest rates and liquidity.

In currency markets, if Rupee short-term interest rates were pushed up, with the world awash with very cheap money, we could end up attracting carry-seeking inflows. This could include foreign flows into Rupee debt, unhedged foreign currency borrowings, and speculative flows. Besides increasing M3, these opportunistic flows could pressure currency markets, hurt domestic producers, and increase external vulnerability.

In all, an excessive reduction in liquidity surpluses and a rise in short-term interest rates today can paradoxically result in higher M3 growth, increase external vulnerability, besides endangering domestic sentiment.

Policymaking may not be as simple as our textbooks suggest.

Notwithstanding the above, practically speaking, what should RBI do now?

RBI is often criticized for being too slow in withdrawing monetary accommodation during 2009-13. While the MPC has pre-committed to an accommodative stance into FY22, from a credibility perspective, it does make sense to gradually withdraw the liquidity punchbowl. In fact, this could perhaps have been initiated alongside the December MPC, when the market was expecting some liquidity withdrawal.

In doing so, however, RBI should ensure that liquidity surpluses and low short-term rates sustain, until credit growth revives. It does not yet make sense to revert to the old policy of keeping the overnight rates close to policy repo rate – that could risk reversible currency flows and M3 growth, besides endangering sentiment.

To be fair, so far, there is no sign of any carry trades in the currency market through FY21. All of the approximately $90 bn purchased by the RBI in spot and forward markets can be explained by our current account surpluses, FDI flows, and FPI equity flows. In line with the impossible trinity, however, the RBI will need to closely monitor global markets and capital flows into short-term debt, even as it modulates liquidity and interest rates.

It must also review its strategy of large forward purchases – the $ 19 bn it purchased in forward markets till October has pushed up the 1-year implied rupee rate in currency markets (MIFOR) to 4.85%, about 1% higher than money market rates. This is hardly conducive to fostering foreign currency outflows – something that would help both current external balance and our M3 context.

Beyond banking liquidity, we need to debate other ways to control M3 growth, while ensuring adequate funding of productive investments – particularly if inflation remains sticky. One path could be to reduce bank funding of government deficits, by providing an attractive window for savers to fund the government (see The case for a Corona bond).

Finally, we need to focus far more on the real economy, and work on creating adequate domestic output and jobs. Output and jobs will lead us to our immense economic potential – not some astute liquidity or monetary framework.