On the pretext of I-CRR
(Prelude: as an instrument, I-CRR may have limited use, but as a concept-making part of banks’ liabilities unremunerative and, thus costly-its has immense disruptive potential)
I-CRRR is an experimental instrument that may be developed and deployed to increase the cost of possessing what can be termed ‘unusable liquidity’. Unusable liquidity is that part of SDF balance that is sticky in the sense it does not come down even when system liquidity, otherwise, tightens substantially.
We have this unusable liquidity largely because of, (a) 24*7 banking led cash-flow issues that force banks to carry surplus balances, and (b) very short term surpluses that banks find difficult to deploy in a better way, eg, surplus o/a of 2k demonetization.
I also have this suspicion that rising AUM of liquid funds and resultant increased activity in the TREPs segment are creating an illusion of excess liquidity!
I reckon the divergence between SDF balance and ‘usable liquidity’ will increase going forward, making it (illusion of liquidity) a risk for the banking system and simultaneously interfering in monetary policy transmission. Under this scenario I-CRR does not work as it can be overcome by fine-tuning the lending rates, if usable liquidity is strained.
On a more speculative level, I think there is a need to understand the relationship between unusable liquidity, growth of liquid MFs and squeezed settlement cycles. Are the efficiency gains in payment & settlement systems and deepening of a part of financial sector creating new risks in liquidity management and monetary policy transmission?
In the last few months, the liquidity in the banking system has risen sharply thanks to the withdrawal of ₹ 2,000 banknotes, the transfer of RBI’s surplus to the government, an uptick in government spending, and capital inflows.
Liquidity surplus in India’s banking system has averaged around ₹ 2.5 trillion in Aug’23, up from ₹1.6 trillion in July ‘23, pushing down overnight borrowing and lending rates.
It is RBI’s consistent endeavour to maintain a balanced system liquidity as excess liquidity situation leads to appreciation in asset prices or increasing inflation risks; whereas a deficit position in the system liquidity mutes investment demand and leads to contraction of economic activities.
The incremental CRR has been imposed after banks stayed away from parking funds with the central bank in last two months at variable rate reverse repo auctions.
An ICRR of 10 percent can take out a little over ₹ 1 lakh crore from the banking system. Despite this, the system liquidity will remain in surplus by more than ₹ 1 lakh crore for the next 1-2 months.
Well written sir. Adding a few thoughts .
‘Drivers of ‘System liquidity ‘are
1. External Sector (Balance of Payments related inflow/ outflow) & the RBI actions of net Forex – purchase / Sale (increase/ reduction in FX-reserves)
2. The Government cash balance (Payments to Govt / Govt -spending)
Reserves with the banking system & Currency in Circulation (CIC) with house holds – are consequential .
The CIC and ‘reserves with the banks’ are components of ‘Reserve Money’. “Payments to and from Government’ and ‘Net forex Purchase/ sale by RBI’ are the sources of the ‘Reserve Money’.
The withdrawal of Rs: 2000 note has resulted in reduction in CIC and increase of reserves with the banking system.
‘AUM of liquid funds’ is part of broad money (part of deposits with the banking system) and therefore is not a driver of liquidity’. As rightly said, it might have created an illusion though!
Absorbing the excess liquidity through SDF resulted in WACR staying lower to the ‘REPO’ rate. The 24* 7 payment cycle prompted banks to park funds in ‘SDF’ rather than in VRRR auctions of RBI. ICRR tool enabled sucking of liquidity without any cost to RBI. The cost of liquidity absorption now is being borne by the ‘Banking System.
More Insights: https://bfi.uchicago.edu/news/the-paradox-of-frozen-liquidity/