The focus of monetary policy is now conclusively on ensuring better transmission. Towards this, for the first time in recent history the RBI has consciously moved liquidity stance to positive. Indeed, the Governor has lately referred to the INR 1 – 1.5 lakh crore positive system liquidity as a comfort factor and facilitator for banks. It thus seems reasonable to infer, in the absence of an official framework on liquidity ‘targets’, that the RBI will want to ensure sustained liquidity surpluses of this magnitude going forward as well.
The micro aspects
As per our estimates, the so-called ‘core’ system liquidity (total banking liquidity minus government balances) is around INR 65,000 crores as at early August. Assuming currency in circulation (CIC) seasonality of last year and superimposing a nominal growth rate to this, the system will lose around INR 2,20,000 crores from here to March 2020. Adding back a higher RBI dividend and some balance of payment accretions, we are largely left with zero core liquidity by end of the financial year. However given the RBI’s current liquidity preference, we would assume they would want core liquidity to be at least be in surplus by a similar magnitude as today. This means that one should reasonably expect further open market operation (OMO) bond purchases from the RBI of at least INR 65,000 – 75,000 crores between now and end of the financial year. A further implication of this is that domestic net government bond supply between October and March is largely agnostic to whether the government decides to do a foreign currency sovereign bond issue or not. This is assuming that say USD 10 billion raised by government from offshore sovereign bonds would have been entirely converted by RBI into rupee liquidity. Thus the need for OMOs would have fallen to that extent.
Refreshing a table we had done in an earlier note, the INR 70,000 crores assumed for sovereign bond issue may just end up getting replaced as RBI OMO should the bond issue not happen.
Source: RBI. IDFC MF Research; all figures in INR crores
While on the subject, one has to comment on the conceptual fallacy in the criticism often levied towards RBI’s OMOs as being monetization of government deficit. Assuming an unwillingness to cut Cash Reserve Ratio (CRR), the only two other tools for policy driven liquidity creation is purchase of forex or bonds. Long term repos are no solution since this is ‘borrowed’ and not permanent liquidity. Given that purchase of forex is a function of flows that the RBI doesn’t directly influence, it has to resort to purchase of bonds for discretionary enhancements in core liquidity. Now if this were being done much beyond the requirements of liquidity creation for the explicit purpose of supporting the bond issuance program or was systematically tied to the quantum of such program or didn’t display two-way directionality, then one could have legitimately argued for backdoor monetization. However, there is no evidence of this as well (more on this below). Thus, any impact from OMOs has to be treated as largely an unavoidable cost of policy implementation just as other tools affect other market variables.
The macro aspects
The chart below summarizes the verdict on whether RBI has been creating too much money.
M3 money supply as % of GDP (quarterly)
Source: CEIC
The chart shows broad money (M3) as proportion of quarterly GDP. As can be seen, after the disruption from the global financial crisis (GFC) had subsided, this ratio had largely settled in a range. This broke lower post demonetization, but hasn’t reverted still to its previous range. This is despite the well acknowledged growth slowdown that has now been underway for some time. Another way to look at this is in the following chart:
M3 and nominal GDP growth (quarterly)
Source: CEIC
This graph tracks growth rates in average quarterly M3 versus nominal GDP. As can been seen, after largely tracking nominal GDP growth rates between 2012 and 2015, M3 growth had started to fall below GDP growth from early 2016, even before demonetization. It is only very recently that M3 growth has been catching back with nominal GDP. It can be argued that a necessary ask from monetary policy in response to the broad based slowdown is for a higher rate of money supply growth than what has been in the recent few years. Indeed, that seems to have been the case also in the ‘golden’ growth period of 2005 – 2008, where M3 growth was much above nominal GDP growth. Assuming no changes to the money multiplier, this implies a higher pace of expansion in RBI’s balance sheet, including through more aggressive purchases of domestic bonds.
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