“…sometimes I've believed as many as six impossible things before breakfast.” – From Alice in Wonderland.
Reserve Bank of India recently announced the recommencement of OMO buying of Indian Government Bonds. We expect a weekly pace of Rs. 120 bn during this buying blitz for at least 10 to 15 weeks starting the first week of December.
Ostentatiously RBI is doing these OMOs “consistent with the stance of monetary policy and based on the current assessment of prevailing and evolving liquidity conditions ..”. Hence, it may be instructional to look at liquidity conditions, as measured by injection/absorption of liquidity by RBI through LAF. The chart below shows 60-working-day moving average of LAF action of RBI for last 10 years.
Chart 1: RBI Injection (+) / Absorption (-) 60-DMA (Rs. Bn) from 2001 till date
Source: Decimal Point Analytics
The above chart shows that the Indian banking system was comfortably liquid for most the decade till end of 2010 – indicated by regular absorption of liquidity by RBI. However, for last 38 months or so, the banking system has flipped, maybe permanently in a state of deficit. It may not be lost to observers that the bank deposit rates went below long-term CPI inflation rates sometime in 2010.
So, it is possible that the persistently observed shortage of liquidity is a manifestation of deeper imbalances in the banking system – may be in the interest rate structure or may be in the mix of assets and liabilities. It would be naïve to address such structural shortage of liquidity through OMOs and in certain cases this strategy can backfire by stoking high inflation.
Another point to consider on these OMOs is the choice of securities. RBI has announced purchase of securities from 6-year to 15-year maturities. If RBI’s main monetary stance is to bring down the inflation rate, and the objective of OMO is to add liquidity, the objective of liquidity management can be better achieved by purchasing short-dated Treasury Bills and Government Bonds. Our analysis shows that short-dated treasury bills and bonds (with maturity less than three years) have outstanding face value of about Rs. 7,000 billion. This large volume of available short-dated securities to purchase, coupled with RBI’s legendary moral suasion, should be sufficient for RBI to stay within the short-end for OMOs meant for liquidity management. The fact that RBI is straying in the longer end of curve for OMOs indicates a different motive – maybe of supporting the large borrowing program of the government, in the guise of liquidity management.
If market believes that the RBI is administering wrong medicine and for wrong reasons, inflation may not come down in the near term and the external value of the Indian unit may suffer further damage. The fight against inflation will become longer and harder to win, in our opinion. Maybe RBI should not believe in too many impossible things before breakfast.