Central Spending Boosts Liquidity, Lowers Overnight Rate Below Repo

A significant increase in government spending following recent elections has enhanced liquidity in the banking system, reducing overnight borrowing rates, Treasury Bill yields, and short-term financing costs for Indian companies. Despite this, the central bank shows no urgency to lower policy rates.

After remaining at or above the Reserve Bank of India’s (RBI) repo rate of 6.50% in May and June, the overnight weighted average call rate (WACR) has averaged 6.39% in July, over 10 basis points below the repo rate, as indicated by daily RBI data. One basis point equals one hundredth of a percentage point. The key factor driving this shift to a surplus in banking system liquidity from a prolonged deficit has been an influx of government spending—about ₹1 lakh crore in recent days.

Gaura Sengupta, Chief Economist at IDFC First Bank, noted that the government’s cash surplus (both Centre and states), which peaked at ₹5.1 lakh crore on May 24 following the RBI dividend, reduced to ₹2.1 lakh crore by July 11 due to increased government expenditure. By June 28, the surplus was ₹3.2 lakh crore, indicating ₹1.1 lakh crore was spent in two weeks, with government expenditure flowing through the banking system.

In July, surplus liquidity in the banking system, as measured by the RBI’s fund absorption, averaged ₹1.1 lakh crore, lowering the WACR, according to RBI data.

RBI’s Liquidity Approach:

In May and June, the banking system mostly faced a liquidity deficit, prompting the central bank to inject funds into the system.

Call Rates Below Repo:

The WACR, the RBI’s monetary policy operating target, is a key determinant of banks' funding costs and corporates' debt-raising costs. It is intended to align closely with the repo rate, moving in tandem with official changes by the RBI.

Bank treasury executives reported that rates on 3-month bank certificates of deposit and commercial papers issued by corporates have eased by 5-7 basis points this month, mirroring the decline in government T-bill yields in July. Government bond yields serve as pricing benchmarks for corporate debt.

Cutoff yields on 91-day, 182-day, and 364-day T-bills have dropped 4-5 basis points in July compared to June, with a more significant 12-15 basis point decline since April 3, driven by the government’s decision to reduce T-bill borrowing in April-June.

The RBI, maintaining vigilance on inflation, has regularly conducted variable rate reverse repo operations to drain excess funds from the banking system, preventing overnight borrowing rates from falling too far below the repo rate. India’s Consumer Price Index inflation rose to 5.08% in June from 4.75% in May. Excess system liquidity poses inflation risks.

Liquidity Management:

“Overall, system liquidity will turn slightly negative (deficit) around the time of GST outflows. By month-end, with government security redemption and robust government spending, we should see a decent liquidity surplus of around ₹1 lakh crore by early August,” said Abhishek Upadhyay, Senior Economist at ICICI Securities Primary Dealership.

Going forward, the central bank’s liquidity approach will be closely monitored, especially as a substantial surplus transfer from the RBI to the Centre allows for accelerated government spending. Additionally, overseas funds are expected to flow into the debt market following the inclusion of local sovereign debt in a JP Morgan bond index.

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