RBI had a tough time in FY20, as managing systemic liquidity was a major challenge for the central bank. During the year, the incremental credit offtake was Rs. 3.68 lakh crore as against Rs. 7.65 lakh crore of incremental deposits. Consequently, a weak credit offtake mired by a mild economic outlook led to high systemic liquidity, which eventually found its way to Government securities – increasing commercial bank investments and collaterals. Commercial bank borrowing however did not abate as RBI’s Repo operations under the LAF window were subscribed fully as well, resulting in compensatory increases in RBI’s holdings of such collaterals in the meantime.

Nevertheless, high FPI/ FDI inflows were absorbed by the RBI through OMO purchases, which resulted in the infusion of further liquidity. In order to sterilize inflationary tendencies, RBI generally engages in market and non-market based instruments such as reverse Repo operation – absorbing excess liquidity in exchange of government securities. Resultantly, even Reverse Repo operations were fully utilized. This resulted in drawdowns of RBI’s collateral holdings and its ability to absorb further liquidity either under LAF or OMO.

The Reserve Money Mechanism

In a normal monetary environment, the above adjustments are achieved via the balancing of RBI’s Reserve Money (RM) components on its balance sheet. While on the liability side, the RM consists of the money in circulation (M1) and Cash Reserve Ratio (CRR) along with bank deposits, the asset side consists of Net Foreign Assets (NFA) and Net Domestic Assets (NDA). As suggested by their respective names, the NFA & NDA hold the RBI’s net foreign and domestic assets, respectively. Importantly, since the asset side of the RM has to equal its liability side equivalent, the domestic and foreign asset holdings have to balance each other out as well. It is already empirically proven that for every 100 bps increase in the NFA, the NDA must go down by roughly (-) 50 bps. These adjustments however do not hold whenever the system is overwhelmed by unabated foreign inflows – creating difficulties in forex management and resultant liquidity.

In FY20, India had received massive capital inflows and consequently, the RBI’s net foreign exchange assets (NFA) surged by Rs. 6.7 lakh crore during the financial year. It is noted that when a central bank absorbs foreign assets, the primary liquidity in the system effectively increases. This liquidity is ultimately further added to the M1 (which positively influences deposits) when offtake is weak – restarting a cycle of increased collateral hoarding by commercial banks during the phase. This is then almost always followed by the drawdown of RBI’s collaterals as the central bank tries to sterilize the spill over effect.

In the period under consideration, we note that while the total RM has increased by only Rs. 3.10 lakh crore, the NFA has increased by Rs. 6.7 lakh crore. This has resulted in a condition where the NFA component exceeded 100% (114%) of RM and 77% of the RBI’s total assets. Due to the enlarged NFA, the space for NDA reduced and the RBI was left with low collaterals to absorb systemic liquidity resulting in an ineffective sterilization effort. This resulted in a situation where even though the RM at both sides adjusted, the rise in liquidity remained unchecked. Selling the NFA components in the open market is also often times difficult because that may have appreciated the domestic currency (in this case the Rupee), which then makes exports uncompetitive and the possibility of more inflows pertaining to covered interest arbitrage opportunity – exacerbating the forex management problem.

Under current scenario, a higher NFA has therefore severely limited the market based liquidity absorption of the RBI. Resultantly, despite a surge in forex reserve (NFA), RBI had to infuse liquidity of almost 3 lakh crore during the financial year in a bid to absorb foreign exchange. This has not only caused inflationary tendencies in the economy but kept the prevailing money market rates below normal for much of FY20.

Increment Amount (Rs. Lakh crore)

Note: * as on March 20, 2020, # purchase (+), sales (-), @ amount is converted to Rupee

Net Foreign Assets (NFA) to Total Assets (TA) of RBI: