UPSC CSE MAINS SYLLABUS- GS – 3- Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.
RBI and Liquidity
On January 8, the Reserve Bank of India (RBI) announced its intention to “restore normal liquidity management operations in a phased manner.” It announced the resumption of variable rate reverse repo auctions, the first of which will be held on January 15, for an amount of Rs 2 trillion, and a tenor of 14 days.
Over the pandemic period, the central bank had taken several steps to infuse liquidity, cut policy rates and eased regulatory norms. The latest announcement comes as a first step towards normalisation.
There are two implications of this step.
- One, as banks park surplus funds with RBI at close to the reverse repo rate of 3.35% for longer periods, the incentive to lend at lower rates could diminish.
- Two, the commentary on restoring normal liquidity could work more broadly as a signal from RBI that it is ready to gradually exit from very loose policy even as it holds on to its accommodative stance. Both of these could nudge short-term rates higher.
- It only directly impacts those financial entities such as commercial banks which have access to RBI’s reverse repo window.
- It leaves out other entities like mutual funds, which may continue to function at lower rates.
Why the measure now:
- While the timing was hard to predict, we were expecting RBI to steer on a normalisation path in 2021 for three reasons:
- One, growth has rebounded strongly with new Covid-19 cases falling rapidly despite rising mobility.
- Two, while CPI inflation may inch lower in December (c5% versus 6.9% last month), it could go back up to over 5.5% by March, led by rising commodity prices, a reversal in the favourable base, and a likely rise in services inflation.
- Three, led by surplus liquidity in the system, several short-term rates such as the overnight call money rate and the 3-month T-Bill rate were trending below the reverse repo rate.
- The market reaction to these steps could help RBI test waters, as it guides short-term rates towards the reverse repo rate and over time closer to the repo rate.
- Some of the roll-back in surplus liquidity is also expected to happen automatically, as the one-year cut in the cash reserve ratio (CRR) reverses in April.
- We expect RBI to raise the reverse repo rate in the second half of 2021 in a bid to narrow the policy rate corridor (the corridor is 65bps wide at present, versus 25bps in early 2020).
POSSIBLE UPSC MAINS QUESTION:
Discuss the RBI’s policy to restart variable rate reverse repo auctions, as a first step towards normalising excess liquidity.