The RBI has decided to go ballistic on liquidity. There’s just too much cash in the system. People deposit money and there are withdrawal limits, so cash stays in bank accounts. The banks don’t have avenues to deploy the cash, so they give them to RBI. And earn interest. Of 6.23% or so, in “reverse repo”.
There’s so much money in reverse repo it’s not funny. About 5 lakh crores as of Friday.
RBI’s new regulation changes that, suddenly and dramatically. They say:
- On the incremental deposits (net demand and time liabilities) between Sep 16 and Nov 11, 2016: banks have to deposit all this extra money with RBI as CRR
- This extra is “over and above” the regular CRR obligation
- Till December 9 – so the mechanism is for one fortnight.
Give Me Figures!
Demonetization was announced on 8 November 2016, but deposits spiked up in two days to a very large number. Between 16 September and 28 October, deposits were already up about 1.8 lakh crore. In the subsequent fortnight, deposits were up to 101 lakh crore.
This means over Rs. 3 lakh crore rupees in India were added to deposits in about two months leading to November 11.
How does the CRR rule impact banks? They Lose 500 cr.
Banks have been parking all this excess money (and a lot more money that they have received since November 11) in with the RBI in special “reverse repos”. This money earns them 6.23% in interest. Not too bad, because they have to pay 4% to savings bank account holders (some banks pay more, but most are at 4%). So they earn the extra 2.23%.
But now, banks have to park this 3 lakh crore into CRR. CRR earns no interest. So banks will pay savings bank interest (say 4%) but earn nothing. 4% for 3 lakh crore is about 32 cr. per day.
For the fortnight, banks will lose about 493 cr. in interest paid out (to SB accounts) but they won’t get any interest from RBI (since this is now CRR).
In reality banks are now getting a lot more cash (they have probably got over 6 lakh crores as deposits, much of it after November 11). That cash will still earn them money if they pour it into reverse repos, so it will offset the impact somewhat.
The Overall Impact: 124% of the money is gone
This 3 lakh crore is just additional CRR. Banks need to put 4% of this money as regular CRR (Rs. 12,000 cr.) And then another 20.75% of this money needs to be in government bonds. (Rs. 62,000 cr.)
That means banks will have to cordon off 374,000 cr. at least, for the next fortnight.
Banks have been trying their best to deploy all the extra money into anything that gives them interest and is safe. To the extent that government bonds have spiked in terms of prices recently, and 91 day T-Bills have fallen to 5.5% in yields.
This CRR increase is temporary, only for 15 days, but the RBI might extend it.
Banks Have The Money, or Will Get It in Two Days
Banks have about 1.5 lakh crore in reverse repos maturing on Monday, so that much can be placed as CRR with the RBI. They will probably sell some bonds to get some money, and will also borrow overnight from the RBI (“repo”) to make the CRR required. In a couple of days, they will have enough money for the excess CRR as more reverse repos mature.
Negative for Banks, Short Term Bonds but not for Long Term Bonds?
Banks will be hit by interest costs on the excess CRR. So this development is negative for them.
Shorter term bonds – from T-Bills to short term paper, both government and commercial paper – will probably be hit, as banks will have to sell them (or won’t buy them enough) in this new CRR regime. More deposits are coming in every day. That money won’t be used to buy bonds because no one knows what the RBI will do next! (They’ll just park in overnight or short term reverse repos)
Long term bonds will not be badly impacted. Because as more deposits come in, 20.75% of them have to be in government bonds. So banks have to continue to buy government bonds to make the SLR limits. While they may sell some bonds initially for liquidity, they will eventually be buyers back again.
Will There Be A Rate Cut?
Inflation is down, growth is hit. A rate cut needs to happen. There’s only two reasons why the RBI won’t cut rates – if they think inflation is a problem (and core inflation is rising indeed), or if they believe the USDINR move to 69 will increase imported inflation (since we import a lot of goods). But this isn’t major. So a rate cut is still on the cards.
A CRR increase may remain till end-December, so that the RBI doesn’t keep paying huge interest on the heavy balances banks want to park with them.
Banks might cut lending rates on December 1. They better; there isn’t any easy money to be made now that RBI will take this excess money from banks at zero interest.
While this measure is sudden, the RBI has done “sudden” things overnight, quite often. The demonetization was one such measure, and honestly, there’s no reason to assume more dramatic actions won’t happen now. We have noted that RBI in the recent past was a transparent, predictable central bank. Now, that is no longer the case and there is a strong take-no-prisoners approach. This is indeed going to be an interesting time.