Tricky interest rate choice for RBI amid problem of plenty

RBI’s special measures to overcome the shortage of dollars have landed it in a surplus liquidity situation. Even though the central bank rolled back the foreign currency non-resident bank deposit scheme a month ahead of its deadline in anticipation of a dollar rush, it still mobilised a substantial $127 billion. The large inflows, which raised the nation’s foreign exchange reserves to a record $729.3 billion, may end up complicating the central bank’s liquidity management operations. Domestic liquidity touched a four-year high, well above RBI’s preferred level of about ₹2.7 lakh crore, according to Barclays. System surplus liquidity stood at ₹9.71 lakh crore as on September 2, and may rise further with inflows from the other two swap facilities open till December—external commercial borrowings and overseas foreign currency borrowings. It’s now estimated that core banking liquidity will likely peak ₹10-11 lakh crore during the upcoming festive season. The shift from shortfall of dollars to a swimming pool of rupees suggests that in public policy, humble policy efforts can sometimes turn counterproductive.

The primary motive was to strengthen the rupee, which had depreciated to a historic low of 96.97 to a US dollar in May. While RBI’s measures prevented the currency from weakening further, the rupee continues to hover around 95 notwithstanding the dollar flush. Some of the surplus will likely be drained due to higher currency demand during the festive season, potential forex interventions and maturities in RBI’s forward book. About $32 billion of the central bank’s forward book is estimated to mature in a year, which could ease the liquidity pressure. But this will not be enough by itself. So, economists expect the RBI to aggressively step in with traditional liquidity absorption tools, such as variable-rate reverse repo operations over and above such auctions worth ₹53.5 lakh crore announced between August 6 and September 2, besides a temporary increase in incremental cash reserve ratio, forex swaps and open market operations to mop up excess liquidity.

The trouble is that surplus liquidity expands the money supply and, as banks have more funds to lend, it puts a downward pressure on interest rates just when the central bank quietly retired the easing bias in its August policy review. If left unmanaged, the excess liquidity can fuel higher inflation—and that must be prevented.