A nice detailed summary of India's liquidity crisis:
Liquidity crisis: where has all the money gone?
In its 73-year history, RBI has never announced a second round of CRR cut even before the first cut takes effect — something it did last week
A one and a half percentage points cut in banks’ cash ratio (CRR), which defines the amount of cash that commercial banks need to keep with the Reserve Bank of India (RBI), infused Rs60,000 crore into the liquidity-starved Indian financial system on Saturday.
There have been occasions in the past when CRR was cut by more than one and half a percentage points. For instance, in November 2001, it was cut by one and a three-quarter percentage points to 5.75% and in July 1974, the cut was even sharper—two percentage points, to 5%. But in its 73-year history, RBI has never announced a second round of CRR cut even before the first cut takes effect—something it did last week.
This shows the seriousness with which the Indian central bank is viewing the liquidity crisis. Till recently, the system had plenty of money. In fact, RBI had to raise CRR by one and a half percentage points in stages since April to drain excess money that was stoking inflation.
Where has all the money gone?
What is the root of the sudden liquidity crunch?
The main source of money in the system in the past two years has been RBI’s dollar buying. The seemingly unending dollar flow pushed the level of the local currency to 39.20 early this year. An appreciating rupee hurts the competitiveness of exporters as their real income in rupee term goes down. So, RBI was buying dollars from the market to stem the rise of the rupee and, for every dollar it bought, an equivalent amount in rupees was injected into the system.
As a result of this, India’s foreign exchange reserve rose to a record $316 billion (Rs1.75 trillion) in May. At the same time, the rupee liquidity in the system increased phenomenally. The excess liquidity was mopped up by the banking regulator through a series of hikes in CRR and floatation of special bonds under the monetary stabilization scheme or MSS. Under this scheme, RBI floated dated securities as well as short-term treasury bills which were not part of the government’s annual borrowing programme to raise money to bridge the fiscal deficit.
RBI is not buying dollars any more as the supply has dried up. It is, in fact, selling dollars to protect the sharp erosion in the value of the local currency as a weak rupee increases the cost of import and adds to the inflation. The rupee has lost some 18% since January and at Friday’s lowest level (49.30 to a dollar), the deprecation was more than 20%.
In October, RBI has been infusing about Rs75,000 crore daily into the system. While RBI’s dollar buying added to the rupee liquidity in the financial system, for every dollar it sells now, an equivalent amount of rupees is sucked out of the system. In October alone, the market estimates that the central bank has sold at least $5 billion. The latest data shows that for the week ended 3 October, India’s foreign exchange reserve declined by $7.8 billion—the highest in a week in past two years—to $283.9 billion. Both dollar sale and revaluation of global currencies contributed to the fall in reserves.
Overall, India’s foreign exchange reserve has gone down by more than 10% or $32 billion since May, signalling RBI’s presence in the currency market as a seller.
RBI needs to supply dollar in the market as other sources are fast drying up. Foreign institutional investors or FIIs, the main drivers of Indian equity markets, have sold Indian stocks worth $10.18 billion this year, net of buying, after pumping in $17.36 billion in 2007. The volume of Indian firms’ overseas borrowing is also coming down sharply as money is becoming more expensive overseas following the global credit crisis. Finally, exporters, who earn dollars and sell them in the local market, too do not have too much of greenback in their kitty as most of them sold their dollar receivables in the forward market, apprehending further appreciation of the rupee. The trend has reversed and they have been caught off-guard.
The only source of dollar at this point is foreign direct investment (FDI) but that can take care of a very small part of the demand. On the other hand, importers are buying dollar aggressively as they fear rupee can depreciate further.
In the first five months of the fiscal year, between April and August, the trade deficit or the gap between the cost that India incurred for importing goods, including oil, and its earnings on exports is close to $51 billion and it has been rising every month.
For instance, in July the trade deficit was $10.79 billion and it rose to $13.94 billion in August. Even if the trade deficit remains at the August level, RBI needs to sell about $690 million daily in the foreign exchange market in the absence of any other supplier.
RBI’s dollar sale is only one of the causes of the liquidity crunch. Oil and fertilizer firms seem to be the biggest guzzler of bank credit, which has risen 24.8% year-on-year till 10 October.
Oil marketing firms need money to bridge the gap between the cost of importing oil and the price at which the product is sold in the domestic market. The government is supposed to take care of the deficit by issuing oil bonds to these firms. The deficit for the past year was some Rs14,000 crore and despite the 50% fall in international crude prices from its peak, this year’s deficit could be around Rs25,000 crore. Since the government has not issued oil bonds yet, the banking system is bearing the burden.
Similarly, banks have also been lending big money to fertilizer firms since government subsidy has not yet been released. This amount could be as much as Rs30,000 crore. The banking system has not yet been reimbursed by the government of the Rs66,477 crore farm loan waiver and debt relief that was completed in June.
The pressure on banking system has further been aggravated by the problems faced by a section of the Indian mutual fund industry—the so-called liquid funds which invest in money market instruments. Some of these funds have invested in short-term commercial papers (CPs) and certificate of deposits (CDs) issued by non-banking finance companies (NBFCs) and in real estate companies to earn high returns. They have also invested in asset-backed securities and bought pools of retail loans in the form of truck finance, car loans, etc. These securities, known as pass through certificates or PTCs, offer higher interest but are illiquid and the funds bear the default risk. Banks were parking their excess money in these funds but now, facing a liquidity crunch, they are withdrawing money from such funds. This is shrinking the size of the funds and, at the same time, drying up resources for firms that were raising money through CPs and CDs. They are now turning to banks for funds, adding to the liquidity pressure.
In August, liquid funds were managing assets worth Rs89,000 crore, about 18% of total assets under management of the Indian mutual fund industry. According to industry estimates, in the past one week, Rs30,000 crore has been withdrawn from liquid and other debt funds, and in the past three months, the withdrawal could be as much as Rs1 trillion.
Finally, the growing mistrust among global banks and their refusal to lend to each other is also affecting domestic liquidity. Most large Indian banks, both state-run as well as private ones, have an overseas presence. The aggressive ones have been building assets overseas by rolling over their liabilities, raised from the inter-bank market. But these money lines are now fast drying up and it is difficult to replenish them as overseas banks are not rolling over the credit any more even though the London inter-bank offered rate (Libor), an international benchmark for interest rate, is soaring. So, if an Indian bank faces a liquidity crunch abroad, it is now being forced to borrow from India, convert the money into foreign currency, and then quickly export the funds to support the bank’s overseas operations.
Last Friday, the government cancelled auctions of two bonds slated to raise Rs10,000 crore but, sooner or later, it has to enter the market as part of its borrowing programme (around Rs39,000 crore) is left to be completed this fiscal year. So, the pressure on liquidity can only rise. How does RBI tackle the crisis? Apart from cutting CRR, it has been infusing money through its repurchase or repo window every day. Under this arrangement, banks borrow from RBI at 9%, offering government bonds as collaterals.
In October, on average, RBI has been infusing about Rs75,000 crore daily into the system.
Theoretically, RBI can cut CRR to zero in stages and the seven and a half percentage point cut—the current level of CRR—can infuse Rs3 trillion in the system. This allows RBI to sell about $60 billion in the foreign exchange market, at the current rupee-dollar exchange rate, to support the local currency. This is little more than 20% of the country’s foreign exchange reserves and double of what RBI has sold since May.
MSS bonds can also be unwound to create liquidity. The outstanding MSS bonds are worth Rs1.73 trillion. Unwinding these bonds will release liquidity not for the entire system but for those banks that had bought the MSS bonds.
However, RBI cannot do this because Indian banks are required to invest certain portion of their deposits in government bonds known as SLR (statutory liquidity ratio— or the ratio of their funds that banks are required to maintain in liquid instruments) securities.
Under the law, 25% of bank deposits must be invested in SLR bonds. RBI has recently brought down the level to 24%, offering a temporary relief to banks. If RBI wants to buy back MSS bonds from banks, their SLR level will go down below 24%. So, along with the CRR cut, RBI also needs to bring down the SLR requirement to free up money.
RBI can also open a special repo window for mutual funds, large NBFCs and housing finance firms, and money can be offered in exchange of AAA-rated securities as collaterals. This will not only ease the pressure on the banking system but also avert the impending collapse of some of the funds and NBFCs. Unlike banks, mutual funds have very small capital base and some of the liquid funds may see their entire capital being wiped out by losses.
Once the government gets Parliament’s nod for oil bonds and subsidy for fertilizer firms and reimburses banks for the farm loan waiver package, money will flow into the system. Besides, this will enable the oil marketing firms to buy dollars directly from RBI, pledging the bonds, easing the pressure on the foreign exchange market.
In a late night statement on Friday, RBI governor D. Subbarao said the central bank “has taken action to inject liquidity into the system as warranted by the situation” and it is “ready to take appropriate, effective and swift action”.
The challenge before RBI now, apart from injecting liquidity, is to break the expectation of a daily depreciating rupee. It has been selling dollars every day in the past few weeks and the pattern of its intervention is predictable, allowing the foreign exchange market to form a view on the currency. This needs to be broken fast. With $284 billion in its kitty, the fourth largest foreign currency chest outside the Euro zone, after Japan, China and Russia, it can afford to be bold in its currency management strategy which is now inseparable from liquidity management.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to [email protected]
