Mumbai: The Reserve Bank of India (RBI) may be pushed to begin tapering excess liquidity in the second quarter of 2021 as price pressures begin to spread beyond food items and concerns mount about possible instability in the financial markets, with overnight borrowing costs plunging below Mint Road’s desired levels.Policy interest rate and the accommodative stance could remain unchanged for much of 2021, but the RBI may begin tweaking its liquidity operations gradually to pull market rates higher, to at least 4%, its benchmark repo rate, the rate at which it lends to banks. Members of the Monetary Policy Committee (MPC) have warned that too much money in the market is visible in the ballooning of asset prices, and that negative real interest rates for too long could adversely alter savers’ behaviour.They “are debating the optimal timing of normalisation,’’ Sonal Varma, economist at Nomura Securities, said after the latest MPC minutes were published Friday. “Sticky core inflation suggests the effective policy rate should be aligned more closely to the repo rate, instead of being below the reverse repo rate, by reducing surplus liquidity. We expect the process of liquidity withdrawal to begin around the end of the first quarter of 2021, or the second quarter.’’Minutes of the last MPC’s December meeting showed that all the six members were unanimous in keeping the policy stance, but half of them warned that low short-term market rates could come back to haunt the central bank. They also suggested the central bank look at regulatory actions to suck out the markets-distorting excess liquidity.“Regulatory exposure norms can help prevent excess low rates driven short-term borrowing that creates risks,” said Ashima Goyal, one of the three independent members. “It is possible to sterilise excess durable liquidity from expansion in foreign exchange reserves, even while durable liquidity remains sufficiently in surplus to be able to absorb exogenous shocks.”Record Low RatesInterest rates in the overnight market rates fell to a low of 3.10% last week, making the RBI’s reverse repo rate, the rate RBI pays banks for keeping excess funds, of 3.35%, ineffective. Furthermore, the MPC has kept repo rates at 4%. In the overnight market where mutual funds also participate, the rate fell to 2.57% earlier this month.“The central bank needs to relook at its intervention strategy of mopping up dollars given that current forex reserves are sufficient to cover any probable rating downgrade,” said Ashhish Vaidya, MD & country treasurer at DBS Bank. Much of the collapse in money market rates is attributed to the flooding of cash due to RBI’s purchase of US dollars which aggregated about a hundred billion since the breakout of the pandemic taking the reserves to a record $578.5 billion.“The excess liquidity is from foreign exchange flows, both through FDI and FII,” RBI governor Shaktikanta Das said. “We are fully aware of the downside risks.”Reversing the CRR Cut It may begin with the Cash Reserve Ratio. RBI could allow the one percentage point reduction effected until March as an emergency measure to lapse, leading to ₹1.5 lakh crore reduction in surplus. If the foreign exchange inflows remain strong, the central bank could come up with the Market Stabililsation Scheme where it sells bonds to suck out cash. It could also invoke the Standing Deposit Facility. But there is a need to accommodate non-banks like mutual funds if it has to address the liquidity problems. 79829125“Giving greater access to reverse repo aids market development as well as short-term sterilisation,” Goyal said in her comments. “Liquidity management tools can be used at any time.”Excess liquidity could add to inflation which is already at a six-year high and above the targeted 4%.“The demand that is stimulated by a reduction in short rates is not accompanied by an offsetting supply boost, and therefore carries greater inflationary risks,’’ said Jayanth Varma, an independent member of the MPC. November inflation has eased to 6.9%, from 7.6% in October. But prices of steel, copper and aluminium are climbing to multi-year highs. Crude Oil is at a nine-month high after seven straight weeks of gains. “RBI needs to relax norms for lending that will encourage banks to expand credit,’’ said A Balasubramanian, CEO at Aditya Birla Mutual Fund. “Once lending resumes, cash in the banking system should come down, rationalising market rates in sync with the policy rate.’’
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