In a monetary system, the only entity that can create or destroy money (liquidity) is the central bank. And this money grows within the financial system through the money multiplier effect. Economists call the former ‘narrow’ money and the latter ‘broad’ money. All financial instruments used for transacting by any ‘user’ of the financial system, including banks, corporations, governments and individuals alike, are linked to this money creation process.
It is no wonder then that the central bank can influence the money creation process through intervention. This intervention happens through expansion and contraction of the central bank’s balance sheet. So what role does the monetary policy ‘rate’ then play, one would ask. Well, policy rate only determines the ‘price’ of liquidity, while the money creation process determines the ‘quantum’ of liquidity available within the financial system.
With this brief in mind, let’s see how things have panned out over the last 12 months. From an average liquidity deficit of about Rs 85,000 crore in November, 2018, the system moved to a surplus of Rs 2.51 lakh crore as on Oct 31, 2019, a swing of about Rs 3.36 lakh crore. This is a fairly large swing in liquidity in such a short timeframe.
Of course, we have seen much larger swings in exceptional times such as the demonetisation exercise and the subsequent remonetisation phase. This steep liquidity injection was achieved through RBI’s active intervention. It conducted open market operations amounting to Rs 2.65 lakh crore since November, 2018 and two foreign exchange swap operations amounting to about Rs 69,400 crore, both of which added to narrow money or core liquidity to the financial system.
Apart from these, RBI’s ‘dividend’ payment to the central government of about Rs 1,76,100 crore and ad-hoc intervention in the foreign exchange market also added to core liquidity. All this in an environment where currency with public increased by about Rs 2,84,600 created a drag on liquidity.
During the same time, the monetary policy committee also shifted its focus towards reviving growth, cutting repo rates by 135 bps since February, 2019 from 6.50 per cent to 5.15 per cent. In fact, the rate movement has been 160 bps, considering the financial system has actually been operating at the reverse repo rate, which currently stands at 4.90 per cent, thanks to the easy prevailing liquidity conditions.
A natural consequence of the above two phenomena has been a steep reduction in rates across the yield curve, especially at the short end. For example, the one-year private bank CD rates moved from about 8.5 per cent in Nov, 2018 to about 5.90 per cent currently, reflecting not only cut in policy rate itself, but more importantly a compression in spread between overnight rate and the one-year private bank CD rates.
A similar phenomenon has been observed across the short end of the yield curve up to the three-year AAA bonds. However, this transmission has been more apparent in the short-term AAA segment of the bond, while being more sluggish in the banking space MCLRs not moving in tandem.
Transmission of reduced policy rates and easy liquidity into lower lending rates in the banking system has been a much debated topic. In my opinion, an important aspect that has been playing a major part in this has been the liquidity mismatch that the banking system has been facing through the remonetisation period, where deposit mobilisation was not keeping pace with credit demand for a sustained period of time. It is only in H1FY20 that we have seen the gap finally narrow, largely on account of reduction in credit demand.
With RBI’s focus clearly set on reviving growth and ensuring adequate liquidity in the banking system, it is more probable now that one would see better transmission of past rate cuts in fresh loans. We have also started seeing bank term deposit rates going down, which signals lower pressure on deposit mobilization.
Such an environment may pose challenges for traditional savers, as chasing higher yields by taking on credit risk may not be the best way forward, given the heightened risk perception in the market.
Such investors can instead look to benefit from debt funds that focus on high credit quality and are positioned at the lower end of the interest rate risk spectrum. This can help mitigate credit risk as well as duration risk.
Kedar Karnik, Fund Manager, DSP Investment Managers, also contributed to this article)