In the inflation fight, a liquidity conundrum

To grasp the dimensions of the issue, do not forget that the US Federal Reserve steadiness sheet expanded from $4.2 trillion to greater than $8.9 trillion by the center of 2022 as a part of its quantitative easing (QE). Below the proposed quantitative tightening (QT), the Fed steadiness sheet has solely shrunk by round $200 billion and the present plan is to scale back it additional by $1.4 trillion by end-2023. The same story is prone to be scripted for the central banks of different superior economies in 2023, probably tightening international greenback liquidity and be a deflationary drag. However the QT path might be bumpy as monetary markets grapple with the decrease liquidity surroundings. Just lately, the Financial institution of England quickly halted its QT and reverted to QE as monetary stability issues immediately dominated the necessity to management inflation. The tremors of worldwide liquidity tightening are already felt in rising and frontier market economies as they seek for capital flows to fund their present account deficit. These challenges might intensify.

Alternatively, international locations akin to India are coping with their home liquidity normalisation. Confronted with a pandemic, the Reserve Financial institution of India (RBI) flooded the banking system with liquidity together with a deep minimize in rates of interest. The sturdy liquidity surplus went up from ₹2.5 lakh crore earlier than the onset of the pandemic to a peak of ₹12 lakh crore. Nonetheless, this liquidity infusion was solely 4% of the gross home product (GDP), a lot decrease than 20-30% of GDP steadiness sheet growth performed by superior economies. Even with a comparatively smaller quantum of liquidity infusion, RBI was in a position to calm the monetary markets.

Liquidity normalisation began in October 2021. When liquidity will get drained, the price of short-term borrowing for corporations, banks and authorities will increase however for a very long time, the Indian monetary ecosystem didn’t really feel a lot ache as the excess was nonetheless greater than enough. This means of liquidity withdrawal was so properly managed that regardless of the banking system liquidity surplus dwindling, credit score development greater than doubled from round 7% in late 2021 to greater than 16% now, with none disproportionate influence on lending charges. On prime of it, the banks stored on shopping for authorities securities which enabled stability in authorities borrowing prices.

This “goldilocks” scenario is altering now. The liquidity surplus within the system is now approaching the pre-Covid-19 degree of ₹3 lakh crore and adjusting for the money balances of the federal government (which lies with RBI), the excess liquidity with banks has come down to simply above ₹1 lakh crore. Clearly, this has pressured banks to supply different funds to fulfill their wants and pushed up in a single day borrowing prices. Some banks are compelled to borrow from RBI at a penal fee known as Marginal Standing Facility (MSF) fee (6.15%) which is larger than the traditional borrowing by the repo fee (5.9%).

The problem is that RBI has restricted choices to deal with this example. Its financial coverage stance remains to be “withdrawal of lodging” and any contemporary liquidity infusion at this second would run counter to this said stance. With none sturdy liquidity provision by RBI, the second half of FY23 might see a number of fascinating developments.

First, financial institution deposit charges are prone to head considerably larger because the competitors for liquidity intensifies. Whereas RBI has hiked repo fee by 140bps between Might and August, the charges on contemporary deposits have gone up by solely 26bps until September. That is a lot decrease than even the 82bps enhance in common lending charges for contemporary loans. This fee differential has brought about an enormous hole between deposit development (9%) and credit score development (16%). The banking system has been partly funding this hole by borrowing from the market by some short-term devices; however the borrowing value in these segments have elevated a lot that financial institution deposit charges must catch up. At current, financial institution deposit charges should not even masking the present inflation. Solely when savers see some actual returns, there might be a swing in the direction of them from different funding merchandise akin to equities.

Second, funding the federal government’s fiscal deficit might be tougher if the banks need to promote some authorities bonds to create liquidity for themselves. The banks are holding considerably larger quantities of presidency bonds than what is remitted. If credit score demand from the personal sector continues and the banks are unable to lift sufficient deposits, then promoting a few of these “extra” authorities bonds might be a method to fund credit score development. Nonetheless, that is extra prone to enhance authorities bond yields and would possibly even feed into larger lending charges.

Third, if the banking system liquidity headwind turns into extra acute then even credit score development might begin faltering. With international sources of funding additionally turning into expensive and scarce, any squeeze in home credit score can derail the nascent personal capex restoration in India.

Charting a path for the banking system liquidity to keep away from a few of these pitfalls goes to be an integral aspect of financial coverage because it concurrently tries to comprise inflationary impulses. If credit score development and low bond yields are to be preserved, then financial institution deposit charges want to regulate larger. Nonetheless, this is able to not create contemporary liquidity within the system and therefore as inflationary pressures recede, RBI ought to take heed to creating sufficient liquidity to make sure cash provide development broadly tracks nominal GDP development.

Samiran Chakraborty is managing director, chief economist, India, Citi ResearchThe views expressed are private