November 27, 2016
Indian banks will have to deposit as cash all the extra money they have been given as a result of demonetisation with the Reserve Bank of India, the central bank announced this weekend.
The RBI made its sudden move after the country’s banks, flush with cash, went on a bond-buying spree, bringing down interest rates and triggering fears of both inflation and even a shortage of bonds.
The central bank said on Saturday evening it was putting in place the temporary restrictions on bond buying to tackle “large excess liquidity in the system”.
Since Narendra Modi, India’s prime minister, announced the withdrawal of 86 per cent of the country’s banknotes on November 8, Indians have rushed to their banks to deposit the old notes. In that time, around 6tn rupees have been put into the banks.
In response, banks have bought up around 4.3tn rupees’ worth of government bonds with the extra money, causing prices to jump and the yield on a 10-year bond yield fall more than 50 basis points to its lowest in more than seven years. Banks have subsequently cut the interest rates they offer to their customers.
Experts said the move suggested the RBI is more worried about the chances of falling interest rates sparking inflation than the recent drop in economic activity causing long-term stagnation. Some said it suggested the RBI was less likely to cut the base rate when it next makes a decision next month.
Shaktie Shukla, founder of Kaithora Capital, told Reuters: “The liquidity sweep will definitely halt the down move in (bond) yields. It will also temper the euphoria pre-RBI policy [decision].”
The decision in the latest in a string of sudden policy changes since demonetisation was announced earlier this month.
Mr Modi had told Indians they would be able to exchange their old notes until December 31, but last week he reversed direction, immediately stopping the swapping of the now invalid currency.
Indians can still deposit the old cash, though reports in Indian newspapers over the weekend suggested the government was considering a minimum 50 per cent tax on any deposits where the customer cannot explain where the money came from.
If the customer does not declare the cash voluntarily, government officials added, a 90 per cent tax could be imposed.
Kunal Kundu, chief India economist at Société Générale, said however: “I think the banks are reacting way to soon to the accumulation of cheap deposits by cutting the various savings rate drastically. Generally the banks tend cut savings rate faster than lending rates. This will prove to be disastrous for the savers, especially the old and the retired.”
He added: “We would continue to expect a rate cut in December despite this move.”
Sonal Varma, India economist at Nomura, said: “This does not have any direct implication on rate cut chances. Although it would suggest that talks of aggressive easing by the RBI are probably unwarranted, as it does not seem to be comfortable with a sharp fall in overnight rates.”
Mr Modi reassured the public on Sunday that the problems that have faced the country since demonetisation would ease within his stated 50-day period. “When I took this decision and presented it to you, I had said this was not normal and was full of difficulties,” Modi told the country via radio.
“I had said then as well that the decision is so huge that it would take at least 50 days to address its impact, and then we could take steps toward a normal situation.”
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