By Suyash Choudhary

IANS: The focus of monetary policy is now conclusively on ensuring better transmission. Towards this, for the first time in recent history the RBI has consciously moved liquidity stance to positive. Indeed, the Governor has lately referred to the Rs 1-1.5 lakh crore positive system liquidity as a comfort factor and facilitator for banks.

It thus seems reasonable to infer, in the absence of an official framework on liquidity ‘targets', that the RBI will want to ensure sustained liquidity surpluses of this magnitude going forward as well.

The micro aspects:

As per our estimates, the so-called ‘core' system liquidity (total banking liquidity minus government balances) is around Rs 65,000 crore as on early August. Assuming currency in circulation (CIC) seasonality of last year and superimposing a nominal growth rate to this, the system will lose around Rs 2,20,000 crore from here to March 2020.

Adding back a higher RBI dividend and some balance of payment accretions, we are largely left with zero core liquidity by end of the financial year. However given the RBI's current liquidity preference, we would assume they would want core liquidity to be at least be in surplus by a similar magnitude as today. This means that one should reasonably expect further open market operation (OMO) bond purchases from the RBI of at least Rs 65,000-75,000 crore between now and end of the financial year.

A further implication of this is that domestic net government bond supply between October and March is largely agnostic to whether the government decides to do a foreign currency sovereign bond issue or not. This is assuming that say $10 billion raised by government from offshore sovereign bonds would have been entirely converted by RBI into rupee liquidity. Thus the need for OMOs would have fallen to that extent.

Refreshing a table we had done in an earlier note, the Rs 70,000 crore assumed for the sovereign bond issue may just end up getting replaced as RBI OMO should the bond issue not happen.

While on the subject, one has to comment on the conceptual fallacy in the criticism often levied towards RBI's OMOs as being monetisation of government deficit. Assuming an unwillingness to cut Cash Reserve Ratio (CRR), the only two other tools for policy driven liquidity creation is purchase of forex or bonds. Long term repos are no solution since this is ‘borrowed' and not permanent liquidity.

Given that purchase of forex is a function of flows that the RBI doesn't directly influence, it has to resort to purchase of bonds for discretionary enhancements in core liquidity. Now, if this were being done much beyond the requirements of liquidity creation for the explicit purpose of supporting the bond issuance program or was systematically tied to the quantum of such program or didn't display two-way directionality, then one could have legitimately argued for backdoor monetisation.

However, there is no evidence of this as well. Thus, any impact from OMOs has to be treated as largely an unavoidable cost of policy implementation just as other tools affect other market variables.

The macro aspects:

As can be seen, after the disruption from the global financial crisis (GFC) had subsided, the ratio of broad money (M3) as proportion of quarterly GDP had largely settled in a range. This broke lower post demonetisation, but hasn't reverted still to its previous range. This is despite the well acknowledged growth slowdown that has now been underway for some time.

After largely tracking nominal GDP growth rates between 2012 and 2015, M3 growth had started to fall below GDP growth from early 2016, even before demonetisation. It is only very recently that M3 growth has been catching back with nominal GDP.

It can be argued that a necessary ask from monetary policy in response to the broad-based slowdown is for a higher rate of money supply growth than what has been in the recent few years. Indeed, that seems to have been the case also in the ‘golden' growth period of 2005 - 2008, where M3 growth was much above nominal GDP growth. Assuming no changes to the money multiplier, this implies a higher pace of expansion in RBI's balance sheet, including through more aggressive purchases of domestic bonds.