Modi 6t rupees bounty risks bond shortage at central bank

[MUMBAI] Prime Minister Narendra Modi's shock ban on high-denomination currency notes may present a tricky situation for India's central bank: a shortage of bonds needed to manage its money-market operations.

As citizens in Asia's third-largest economy rushed to submit now defunct 500 rupee (S$10.48) and 1,000 rupee bills, about 6 trillion rupees have been deposited at lenders since Mr Modi's move on Nov 8.

Banks had a record 4.3 trillion rupees parked with the Reserve Bank of India against bonds as of Nov 22, according to India Ratings & Research Pvt. That's fast-approaching all of the 7 trillion rupees worth of notes the RBI has on its books to offer as collateral to banks parking excess funds with it.

The situation calls for action from authorities as a banking system awash with unused cash could cause borrowing costs to crash, threatening to hurt financial stability in the US$2 trillion economy.

While the RBI risks running short of bonds to offer to banks, the European Central Bank was earlier this year faced with a dearth of securities to purchase under Governor Mario Draghi's bond-buying programme.

"The pace of increase in banking system liquidity suggests that the RBI may have to soon resort to liquidity mopping up tools that are beyond its current tool chest," said Vivek Rajpal, an interest-rates strategist at Nomura Holdings Inc in Singapore.

"We can reach a situation wherein the RBI resorts to tools like issuing cash-management bills or a standing deposit facility where it sterilises without need of collateral."

Mr Modi's move sucked out 86 per cent of India's currency in circulation, giving people until Dec 30 to exchange the defunct notes for fresh ones. The decision, aimed at weeding out unaccounted wealth and curbing tax evasion, rattled the world's second-most populous nation, where about 98 per cent of all consumer payments use cash.

"We have a number of tools to deal with these issues," a spokeswoman for the RBI wrote in an e-mailed response to questions.

The monetary authority already seems to have started draining out excess funds by increasing amounts and tenures of reverse-repurchase agreements under its liquidity-management operations. The 4.3 trillion rupees parked with the RBI far outstrips the previous record of 1.7 trillion seen in May 2009, according to India Ratings, a unit of Fitch Ratings.

The biggest currency swap in India's history has been complicated by the temporary caps that the government has put on the amount of cash people can withdraw from banks while it prints new notes to replenish the funds. That's making it hard to estimate how much of the deposits will remain in the system after Dec 30.

Temporary Measure

"Whether some of these deposits stay or they get withdrawn over time remains to be seen," said S Naganath, Mumbai-based chief investment officer at DSP BlackRock Investment Managers Pvt, which oversees about 509 billion rupees in assets.

"You'll probably withdraw all of it because the money was your preferential liquidity that you held with you."

The government's decision is expected to disrupt economic activity and damp consumption in the short term. Credit Suisse Group AG and Deutsche Bank AG have already slashed their economic growth forecasts for India. Goldman Sachs Group Inc said in a Nov 22 report that the RBI may opt to sell bonds via its open-market operations to reverse some of the liquidity it has injected over the past year, if it feels the excess system liquidity is "durable" in nature.

"It is an unprecedented and irregular situation," said Soumyajit Niyogi, a Mumbai-based associate director at India Ratings. The RBI will have to resort to short-term tools like cash bills if it wants to keep money markets stable.

Another "temporary measure" could be to raise the cash reserve ratio, said Indranil Pan, chief economist at IDFC Bank Ltd in Mumbai. The CRR can be cut again once liquidity in the banking system stabilises in the first few months of 2017, he said.

Banks in India need to set aside a minimum of 4 per cent of their deposits as cash with the RBI, called the cash reserve ratio, without earning any interest on them.

BLOOMBERG