To provide financial stimulus to the economy during the Covid pandemic, India’s central bank injected ample liquidity into the system. However, with the economy improving, and inflation becoming a bigger threat, over the past few months, the Reserve Bank of India (RBI) has been using various tools to absorb liquidity from the banking system in India and strike a balance between growth and inflation. The most used method is to attract banks with lower reverse repo rates (the interest that RBI pays to banks for the funds that the banks deposit with it) so that they deposit funds with the central bank. However, in April, RBI decided to keep the reverse repo rate unchanged at 3.35 per cent. Instead, it used the provision for standing deposit facility (SDF) to absorb liquidity from the system.
What Is SDF?
- SDF is a tool through which the central bank can absorb liquidity without offering any collateral to banks
- The other tools that the central bank has been using for the same purpose include reverse repo and variable rate reverse repo auctions
- SDF is a part of RBI’s liquidity adjustment facility (LAF). The latter is used to absorb or pump in liquidity into the system
- At the lowest level is SDF (3.75 per cent currently) and the highest is marginal standing facility (4.25 per cent at present), and together they form the two ends of the LAF corridor
- SDF is used to absorb liquidity while the marginal standing facility is used to inject liquidity
- The policy corridor is the difference between the rates at which RBI accepts money and gives money
How Does It Work?
- SDF helps RBI manage liquidity as banks can park their excess funds with the central bank and earn a higher rate of interest on that
- For funds deposited under SDF, RBI does not have to offer security, such as government securities, to banks
- With the higher SDF rate, the difference between the lowest and highest rates under LAF is now 50 basis points, which was the pre-pandemic level
- By introducing SDF and leaving the reverse repo rate undisturbed, interest rates have been raised but not the key rates
- The quantum of excess liquidity in the market is about Rs 8.32 lakh crore. RBI aims to withdraw this liquidity in a slow and calibrated manner
- The SDF rate is applicable on overnight deposits at present
How Does It Help?
- About Rs 5 lakh crore liquidity injected during the pandemic has already been absorbed
- However, towards the end of the previous financial year, while RBI had set a target of Rs 1.5 lakh crore via two variable rate reverse repo auctions, banks supplied only Rs 1.15 lakh crore
- For the balance, the central bank will try to attract banks with SDF at 3.75 per cent, which is beneficial for banks as the reverse repo rate is lower at 3.35 per cent
- Lower liquidity is one of the ways through which the central bank is trying to control inflation
- Consumer Price Index-based inflation was a high of 6.95 per cent in March, while the Wholesale Price Index-based inflation was at 14.55 per cent