Demonetisation – Absorbing the Excess Liquidity

The decision to raise the limit for issue of bonds under MSS (Market Stabilization Scheme) is a prudent move and brings this innovative scheme in focus again. The arrangement also shifts the burden of holding cash from the Banks and RBI on to the government and would help stabilise the money market. A look at the scheme and how money is flowing after it is being deposited in the banks as a result of demonetization.

MSS was introduced in 2004 to sterilise the market from excess liquidity primarily arising out of surge in foreign inflows. The inflow was causing disruption to the money market since the total money getting pumped into the system was more than the market needs including government borrowings. As per an agreement between central government and RBI, RBI was permitted to absorb this money through issue of fresh government bonds. Funds so raised are accounted separately and neither forms a part of total liability of the government nor is the government free to use these funds. However, government does pay interest on these funds. At the end of FY08, before the global financial crisis, total funds under this scheme stood at little over Rs 1 lakh crore.

The current situation is somewhat similar although the surge this time is from internal sources. With increasing deposits, bank’s liability to pay interest increased. Banks, in turn, parked these funds with RBI under reverse repo window since there is no immediate demand for credit. Since RBI has to pay interest on these deposits, the burden of interest gets passed on to RBI. Some of this money was still finding its way to money market and had the potential to disrupt the market. To stabilise the market, RBI, as a temporary measure, raised CRR (Cash Reserve Ratio) to 100% for deposits received after 8th Nov. CRR is the fraction of total deposits banks have to keep with RBI as a hedge against any shortage of money bank may face. Funds parked as CRR doesn’t earn any interest and therefore, is a cost to the bank. Even assuming 2% as the average cost of funds, the daily cost for banks works out to around Rs 50 crore for Rs 10 lakh crore of additional deposits raised so far.

To reduce this burden, government has now allowed RBI to absorb up to Rs 6 lakh crore, up from the limit so far of Rs 30,000 crore only. The permission allowed RBI to conduct its first auction on 2nd Dec and absorbed for Rs 20,000 crore at an annualised interest rate of 6.16%.

Source: Indian Economy & Business

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