BT Explainer: What is VRRR auction and why is it key to RBI’s liquidity management post FCNR (B) boost?

The Reserve Bank of India (RBI), which has been conducting overnight to seven-day variable rate reverse repo (VRRR) auctions, is set to conduct a Rs 7 lakh crore VRRR auction with a 30-day tenor on Monday, September 7.

The move comes at a time when the system is flush with liquidity, largely driven by much higher-than-expected inflows via Foreign Currency Non-Resident (Bank) [FCNR (B)] deposits during the special concessionary swap window announced earlier by the central bank.

The RBI has routinely used VRRR auctions to mop up liquidity. The tool returns to the spotlight after the June special window — launched to shore up foreign exchange reserves amid rupee depreciation pressures — garnered $127 billion.

This far exceeded market expectations of $80-90 billion and dwarfed the $26 billion raised during a similar window in 2013.

What is a VRRR auction? 

The RBI has various tools at its disposal to manage overall liquidity in the system. The reverse repo rate is the interest rate the central bank pays commercial banks when borrowing money from them; raising it allows the RBI to absorb more cash from the market.

VRRR serves as a liquidity absorption tool, typically deployed over short horizons ranging from a single day to a few weeks. Excess cash moves from banks to the Reserve Bank, leaving lenders with less liquidity to lend out. As the name suggests, the interest rate is variable and determined through competitive bidding among banks.

Liquidity management is critical because excess cash in the system can drive down short-term interest rates, which could spur spending and elevate inflation concerns.

Why liquidity management will be key 

Aided by massive FCNR (B) inflows, foreign exchange reserves hit a record $740.8 billion in the week to August 28. These reserves will prove useful should the rupee come under pressure amid the ongoing conflict in West Asia.

The banking system remains flush with liquidity on the back of FCNR (B) deposits and continued government spending. Meanwhile, India’s economy stands on a strong footing, with real GDP growing a better-than-expected 7.8% in the April-June quarter despite the geopolitical crisis.

Inflation, on the other hand, rose to 4.45% in April compared to 4.38% in June, with concerns that it may have climbed further in August due to geopolitical tension and lower-than-expected El Niño rains. Against this backdrop, the RBI will have to deftly manage growth-inflation dynamics while controlling liquidity.

Is VRRR the only tool? 

Not quite. As Sonal Varma, Nomura’s chief economist for India and Asia ex-Japan, notes, the central bank may employ an array of tools to absorb liquidity. The options include continued VRRR operations, an incremental cash reserve ratio (CRR) hike for 2-3 months (CRR being the minimum cash balance banks must maintain), and sell-buy swaps.

A sell-buy swap allows the RBI to sell foreign currency to commercial banks while agreeing to buy it back at a specific future date.

“On the liquidity front, the RBI faces the issue of plenty, as banks that successfully garnered dollars through the scheme, now have surplus liquidity. As a result, the weighted average call rate (interest rate charged on very short-term loans between banks) has dropped below the policy repo rate. While some of the surplus banking liquidity will be offset by higher cash in circulation during the upcoming festive season, maturity of forwards, and due to any potential RBI forex intervention (dollar selling), the RBI may have to employ a panoply of liquidity absorption tools to mop up this surplus,” said Varma.

However, how much interest this longer-term VRRR auction attracts remains something to watch closely.