Despite being the world’s fastest growing major economy, India is having trouble in mustering enough ammunition to sustain its momentum. The economy it seems is running out of cash and systemic liquidity has fallen much faster than anticipated.
Given the situation, India’s central bank, the Reserve Bank of India, popularly known as the RBI has been infusing money into the system through open market operations (OMO). The instrument allows the RBI to purchase dated Government securities in the open market and infuse liquidity in return. This liquidity enters the banking system since commercial banks are the primary hoarders of such securities in India.
RBI is touted to use all its fire power to stabilize the structures and has infused $10.25 billion so far with a further $5.5 billion coming in November. More such injections are expected over the next six months to reach some kind of a systemic halcyon.
The Warning Signs
The weighted average call money rate (WACR), which is the average of all call money rates governing India’s short term liquidity demand has been very volatile lately. Often termed as India’s version of the London Interbank Offered Rate, the WACR is a proxy for assessing overnight volumes among banks. Worryingly, the rate has been consistently trending near the benchmark rate and understandably banks have been scrambling for cash. One possible explanation to this is the RBI’s exit from its long held neutral to accommodative liquidity stance, which equates to general accommodation.
As the systemic liquidity is reoriented towards the so called ‘calibrated tightening’ stance, the central bank was absorbing money as it considered it to be inflationary. This belief system has its roots firmly attached to the lingering effects of the 2016 demonetization exercise, when the Indian Government deemed high denomination currency notes illegitimate, overnight. In a bid to exchange old notes with the new, banks were oversupplied with deposits – taking systemic liquidity to record levels. The event resulted in the WACR/ benchmark rate differential to peak 32 bps in April 2017; astounding because this number rarely goes beyond 15.
What worried the central bank was the fact that cash rich commercial banks increased their credit offtake or lending operations – aiding risky businesses. This was causing inflationary pressures as well because heightened personal loans were aiding pressures in core inflation. Since then, the RBI has been pulling money out by exercising two options, first via the Reverse Repo operations under the Liquidity Adjustment Facility and second through the mentioned OMOs.
Turmoil in the capital markets and a threatening asset liability mismatch
As interest rates started to rise in anticipation of a higher inflation and the rapidly normalizing interest rates in the United States – capital markets suddenly became less attractive. As suggested by falling equity valuations and bond yields going up, investors were in a panic mode. Since the start of the 2019 financial year, foreign portfolio investors have pulled out nearly $13 billion from the Indian capital markets. The US India benchmark yield differential is also now below its traditional buffer of 500 bps, thanks to a quicker Fed rate hike cycle and the RBI’s inherent reluctance in raising rates enough on account of domestic stability. Capital market debt issuances as a result have declined by 30% since the start of this financial year and duration risk is making issuers nervous about the future. With that said, corporations are turning towards the old-fashioned ways of financing – banks.
However, RBI absorptions as part of its normalization exercise reduced cash in the system and the heightened demand for credit is now making life difficult for businesspeople. Worsening the situation, growth in deposits is slower than that of credit in the Indian banking system and that is creating an adverse credit to deposit ratio. Commercial banks are now anxious about a potential ‘asset liability mismatch’ and becoming extra cautious; this is further starving the system of cash. Such has been the impact of this crunch that the WACR/ benchmark rate spread reached parity in September this year before eventually turning negative. The insecurities in the overnight lending among banks were therefore apparent and started to impact even the short term money market instrument valuations.
Old Wine; New Bottle
Historically, India has been an illiquid market. While such a situation prevails in most emerging markets, India’s case is special primarily because of its domestic demand orientation. Considering its current rate of economic expansion, the Indian economy cannot sustain for long until the liquidity situation is sorted. The impending demand for cash as the holiday season begins will worsen the situation. In its final attempt, the RBI is selling parts of its massive foreign currency reserves to not only stabilize the rupee but infusion of exchanged rupee back into the system in the form of cash. Doing this, the central bank has already sold $32 billion of these reserves and might consider this again if instability continues. As things stand today, the liquidity situation is grim and requires a serious rethinking. The central bank is expected to take evasive steps to calm the system – the costs may however be underestimated at the moment.