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News: Further expansion of RBI’s balance sheet without normalizing credit offtake (demand for credit) will only raise economic risks.
How RBI manages its balance sheet?
RBI’s balance sheet consists of the asset side and the liability side.
Reserve Money (RM) or base money – Asset side: It consists of net domestic assets (NDA) and net foreign assets (NFA).
Reserve Money (RM) or base money – Liability side: it is composed of Currency in Circulation (CIC) and Deposits made by banks.
During normal operations, RBI balances the two accounts, the Asset side and the Liability side.
However, during extraordinary situations like the Pandemic, the RBI gets inundated by cheap money from overseas due to ‘quantitative easing’.
This disturbs the RBI’s balance sheet by making the Asset side component disproportional to the liability side.
In order to balance, RBI adjusts the liability side by increasing the Currency in Circulation (CIC), thereby creating new money.
But again, when monetary policy normalization occurs in the developed world, capital flight occurs in emerging markets like India. During this phase, capital flight creates demand for dollars, depreciating the rupee.
RBI intervenes in the open market to stabilize the rupee, selling some of its dollar reserves. While reducing its net foreign assets (NFA), this process increases its net domestic assets (NDA).
How excess liquidity created during the quantitative easing phase is being managed?
Theoretically, CIC already created leads to the formation of broad money with the help of a multiplier effect.
The subsequent liquidity in the system will be absorbed into RBI’s balance sheet through the liquidity adjustment facility (LAF), balancing out the asset side and liability side as per the state of credit demand.
Additionally, an expanding economy and a rise in credit demand results in a steady deposit rate. Resultantly, bank deposits with RBI in the form of a cash-reserve-ratio (CRR) increase, completing the Reserve money adjustment on the liability side.
What is the current anomaly?
Throughout the current crisis, the continuous inflow of foreign money increased foreign currency assets, creating new money that had nowhere to go.
This dilemma was caused by weak credit offtake for much of the pandemic, along with rising deposits.
RBI responded via massive reverse repo operations, that resulted in increasing its deposit account and contributed vastly to reserve money.
What are the implications due to flight of capital?
Opportunities: While market volatility is creating a difficult situation for the rupee, for RBI’s balance sheet, such conditions are supportive. Global volatility involving outflows raises the value of foreign holdings on the asset side.
Risks: As credit offtake picks up, reverse repo operations will decline, opening space for an increase in CIC. This is often inflationary and may result in the rupee losing value.
Any further growth in Net Foreign Assets (NFA) without simultaneous degrowth in deposits will create incremental CIC, expanding RBI’s balance sheet unintentionally.
Also, in the event of rapid rupee depreciation, RBI will have no option but to use its reserves to safeguard the currency, exposing its balance sheet to external shocks.
Source: This post is based on the article “The curious case of India’s rising forex reserves and falling rupee” published in Livemint on 13th Dec 2021.