A synchronised increase in global interest rates has been the focus of financial markets in recent times. While this triggered a lot of discussion around the risks of a global recession being caused by these hikes, the markets seemed to have broadly priced in the expected hikes from central banks. But can the inflation genie — which seems to be out of the bottle now in the developed world — be put back with only rate hikes or is there a need for tightening liquidity?
To understand the scale of the problem, remember that the US Federal Reserve balance sheet expanded from $4.2 trillion to more than $8.9 trillion by the middle of 2022 as part of its quantitative easing (QE). Under the proposed quantitative tightening (QT), the Fed balance sheet has only shrunk by around $200 billion and the current plan is to reduce it further by $1.4 trillion by end-2023. A similar story is likely to be scripted for the central banks of other advanced economies in 2023, potentially tightening global dollar liquidity and be a deflationary drag. But the QT path could be bumpy as financial markets grapple with the lower liquidity environment. Recently, the Bank of England temporarily halted its QT and reverted to QE as financial stability concerns suddenly dominated the need to control inflation. The tremors of global liquidity tightening are already felt in emerging and frontier market economies as they search for capital flows to fund their current account deficit. These challenges could intensify.
On the other hand, countries such as India are dealing with their domestic liquidity normalisation. Faced with a pandemic, the Reserve Bank of India (RBI) flooded the banking system with liquidity along with a deep cut in interest rates. The durable liquidity surplus went up from ₹2.5 lakh crore before the onset of the pandemic to a peak of ₹12 lakh crore. However, this liquidity infusion was only 4% of the gross domestic product (GDP), much lower than 20-30% of GDP balance sheet expansion done by advanced economies. Even with a relatively smaller quantum of liquidity infusion, RBI was able to calm the financial markets.
Liquidity normalisation started in October 2021. When liquidity gets drained, the cost of short-term borrowing for firms, banks and government increases but for a long time, the Indian financial ecosystem did not feel much pain as the surplus was still more than adequate. This process of liquidity withdrawal was so well managed that despite the banking system liquidity surplus dwindling, credit growth more than doubled from around 7% in late 2021 to more than 16% now, without any disproportionate impact on lending rates. On top of it, the banks kept on buying government securities which enabled stability in government borrowing costs.
This “goldilocks” situation is changing now. The liquidity surplus in the system is now approaching the pre-Covid-19 level of ₹3 lakh crore and adjusting for the cash balances of the government (which lies with RBI), the surplus liquidity with banks has come down to just above ₹1 lakh crore. Obviously, this has pressured banks to source alternative funds to meet their needs and pushed up overnight borrowing costs. Some banks are forced to borrow from RBI at a penal rate called Marginal Standing Facility (MSF) rate (6.15%) which is higher than the normal borrowing through the repo rate (5.9%).
The challenge is that RBI has limited options to address this situation. Its monetary policy stance is still “withdrawal of accommodation” and any fresh liquidity infusion at this moment would run counter to this stated stance. Without any durable liquidity provision by RBI, the second half of FY23 could see several interesting developments.
First, bank deposit rates are likely to head substantially higher as the competition for liquidity intensifies. While RBI has hiked repo rate by 140bps between May and August, the rates on fresh deposits have gone up by only 26bps till September. This is much lower than even the 82bps increase in average lending rates for fresh loans. This rate differential has caused a huge gap between deposit growth (9%) and credit growth (16%). The banking system has been partly funding this gap by borrowing from the market through some short-term instruments; but the borrowing cost in those segments have increased so much that bank deposit rates need to catch up. At present, bank deposit rates are not even covering the current inflation. Only when savers see some real returns, there could be a swing towards them from other investment products such as equities.
Second, funding the government’s fiscal deficit could be more challenging if the banks have to sell some government bonds to create liquidity for themselves. The banks are holding significantly higher amounts of government bonds than what is mandated. If credit demand from the private sector continues and the banks are unable to raise enough deposits, then selling some of these “excess” government bonds could be a strategy to fund credit growth. However, this is more likely to increase government bond yields and might even feed into higher lending rates.
Third, if the banking system liquidity headwind becomes more acute then even credit growth could start faltering. With global sources of funding also becoming costly and scarce, any squeeze in domestic credit can derail the nascent private capex recovery in India.
Charting a path for the banking system liquidity to avoid some of these pitfalls is going to be an integral element of monetary policy as it concurrently tries to contain inflationary impulses. If credit growth and low bond yields are to be preserved, then bank deposit rates need to adjust higher. However, this would not create fresh liquidity in the system and hence as inflationary pressures recede, RBI should be conscious of creating enough liquidity to ensure money supply growth broadly tracks nominal GDP growth.
Samiran Chakraborty is managing director, chief economist, India, Citi ResearchThe views expressed are personal
