How RBI could tackle a liquidity deluge triggered by dollar deposits

MUMBAI: The Reserve Bank of India's special dollar deposit scheme drew a larger-than-expected $127.23 billion, leaving the central bank having to deal with a problem of plenty.

The dollar deposits, swapped by banks directly with the RBI, have pushed the liquidity surplus in India's banking system to a record high of 9.70 trillion rupees ($102.70 billion).

Also Read: India's bank liquidity surplus hits all-time high


Traders are debating how the central bank may absorb these funds, as allowing them to slosh around could fan already-rising inflation.

LONGER-TERM VARIABLE RATE REVERSE REPOS

The central ‌bank routinely conducts ⁠overnight to ⁠seven-day variable rate reverse repo (VRRR) auctions to suck out liquidity. Typically these operations lock up liquidity for a few days.

But the central bank ​could conduct longer-term VRRRs while giving banks the option to reverse them early, traders said.

"Repos conducted in this format saw ​reasonable success at the start of the calendar year, so it could offer a win-win solution for all parties," according to a trader at a primary dealership.

Also Read: Record FCNR (B) inflows as banks mobilise $127 bln

FX SWAPS

The central bank could also use shorter tenor dollar-rupee sell-buy swaps. ​By selling dollars or taking delivery of a part of its forward ⁠positions, the ‌central bank can drain rupee liquidity.

Given the liquidity influx, the RBI may be comfortable in taking delivery of around $32 billion from its forward book, which is due to mature in one ⁠year, said Madhavi Arora, an economist at Emkay Global.

MARKET STABILISATION SCHEME

The RBI and ​the government could also bring back a previously used market stabilisation scheme, ​last used in 2017 after a decision to scrap high-value currency notes led to a surge in banking system liquidity.

Under this scheme, the government sells shorter-tenor Treasury bills, which could absorb surplus liquidity for up to one year.

The government is typically not in favor of this tool since it has to pay interest on these securities, traders said.

CASH RESERVE RATIO

The most commonly used tool to withdraw rupee liquidity is the cash reserve ratio, the ‌proportion of deposits that banks are required to hold as reserve. The CRR is currently at 3%.

Several market participants believe the central bank could temporarily raise banks' CRR requirement, ​particularly on deposits mobilised ​through the discounted window.

Other traders ⁠say the central bank could opt for a broader CRR hike on all deposits.

A 50 basis point CRR hike could withdraw around 1.4 trillion rupees, and a 100 bps increase could suck out around 2.8 trillion rupees ​from the system, market participants estimate.

OPEN MARKET BOND SALE

The RBI can also sell government bonds that it is holding to investors.

Such a move could withdraw liquidity but would also push up bond yields.

"OMO sales could mitigate the risks associated with narrowing interest rate differentials," said Upasna Bhardwaj, chief economist at Kotak Mahindra Bank.

"Based on our estimates of the RBI's holdings, most bond sales are likely to be concentrated in the three-year to 10-year segment."