Last year, the daily average surplus funds of the banking system was over Rs 34,600 crore (Rs 346 billion). The Reserve Bank of India used to drain excess liquidity through its reverse repo auctions.
Until November 10, there was no dramatic change in the scene, though the quantum of average daily surplus money with the banking system dropped to around Rs 22,000 crore (Rs 220 billion) this year.
On November 10, the system ran dry and the RBI had to infuse Rs 5,175 crore (Rs 51.75 billion) through a repo auction.
The reverse repo window is used by the RBI to suck excess liquidity out of the system at 5.25 per cent interest while it extends liquidity support through the repo window at 6.25 per cent.
Since November 10, the RBI has pumped in over Rs 15,000 crore (Rs 150 billion) of liquidity into the system through its repo window. Besides, it has also cancelled three auctions of treasury bills under the market stabilisation scheme (MSS).
After the twin-move, overnight call rates, which were hovering around 6.5-7 per cent last week, dropped to 5.5 per cent today.
With no sign of a slowdown in the credit offtake, the liquidity situation can only get worse with an estimated outflow (net of rollover) of over Rs 22,000 crore worth of India Millennium Deposits in December. Does this mean that all is over on the liquidity turf and from now on it can only tighten leading to hardening of interest rates?
Let us take a close look at where the money came from and where has it gone.
A major source of liquidity has been the foreign exchange inflow and the huge build-up in the RBI's foreign assets. The RBI bought dollars from the market and pumped in an equivalent amount of rupee into the system.
In fiscal 2003, forex inflow was $17 billion which went up to $31 billion in fiscal 2004 and $26 billion in fiscal 2005. This year, it has been only $6 billion.
Between fiscal 2001 and fiscal 2004, there was surplus on capital account as well as current account.
While the capital account continued to be surplus this year ($7.1 billion against $32.2 billion in fiscal 2005), first quarter current account of fiscal 2006 has been $6.2 billion (against $6.4 billion for the entire last year) and it can rise to a 15-year high deficit of 2.2 per cent of the country's GDP by the year-end, thanks to the large pick in non-oil imports and the rising oil prices.
This is the supply side story, while the demand for funds is increasing. The incremental credit deposit ratio continues to be over 100 per cent. The non-food credit is growing by 30.9 per cent (Rs 1,42,910 crore, in absolute term) this year on top of last year's 27.6 per cent growth (Rs 2,31,124 crore).
With the rising demand and dwindling supply, the liquidity strain can only intensify. The IMD redemption will add to the woes of the system.
However, there is no panic yet as the RBI has enough ammunition to prop up the supply of funds. It has already cancelled three auctions of MSS and can repeat the action to unwind liquidity.
If the situation demands, it can even buy back part of the Rs 67,600-crore (Rs 676 billion) of funds locked in MSS ahead of their redemption and ensure faster release of money into the system.
Besides, the government is running about a Rs 20,000-crore surplus with the RBI. This means, the government has borrowed this money from the market but not spent it yet, possibly on account of better expenditure management.
This is highly unusual as the government normally spends more by drawing from its ways and means advances account kept with the RBI. Once the government starts spending, this fund will come back to the system.
Finally, the RBI can always cut the cash reserve ratio of banks to infuse liquidity in a crunch situation. On September 14 last year, it had raised banks' CRR by half a percentage point to 5 per cent.
An identical cut will infuse about Rs 10,000 crore (Rs 100 billion) into the system and it will create about Rs 48,000 crore (Rs 480 billion) worth of funds over the next one year because of the multiplier effect.
The impact of tight liquidity is felt in short-term rates but the overall yield curve has not felt the impact yet. While there is no panic in the short-term, in the medium- to long-terms, liquidity will tighten, leading to a rate hike.
This is a global phenomenon and India cannot be an exception. If the international crude oil price continues to remain low, it can delay the hike for the time being and the RBI may refrain from tinkering with rates in January when the quarterly review of the monetary policy is due.
More from rediff