To understand what happens to “supply of money” in the market when RBI buys $, let us first discuss about what’s the nature of liquidity.
As per the RBI policy statement of April, liquidity are of two nature- Durable and short-term/temporary.
Temporary liquidity shortage arises when there is a mismatch between assets and liabilities for a short-period of time. In such cases, banks borrow from the call money market. However, to borrow, there has to be lenders with surplus funds. If most of the banks do not have funds to lend, the call money market rates may go very high. This is a situation where the entire banking system may need funds or it not willing to lend at lower rates.
Thus, Frictional/short term liquidity injection is through repos that help to replenish government cash balances.
Repo rates are short-term rates. Repo rates usually impact long-term rates when there is an increase in “long-term/durable” liquidity.
After RBI’s credit to government, changes in net foreign assets have become a major source of the creation of reserve money. Reserve money is made up of Currency in Circulation + Bankers’ Deposit with RBI+Other Deposits with RBI.
Data on Reserve Money
When RBI buys foreign exchange from the market, it pays for the same in rupees thereby injecting “rupee liquidity” into the market. Along with forex operations, intermittent OMO operations also help RBI to manage the durable liquidity added into the system.
Durable liquidity is long-term in nature. It is usually through OMOs or $ purchases by RBI to provide liquidity after the currency leakage or dollar sales by RBI in times of weakness in Rupee.
RBI Monetary Policy Statement of April 2016:
Experience suggests that the provision of short term/frictional liquidity does not substitute fully for durable liquidity, though durable liquidity can substitute for short term/frictional liquidity needs
In its April policy statement, RBI had decided to “smooth the supply of durable liquidity over the year using asset purchases and sales as needed”.
However, the expansion of reserve money through increase in foreign exchange assets could also create a scenario of surplus liquidity in the banking system’. RBI then issues/sells its holdings of government securities and receive rupees for it. This would absorb the liquidity created from forex operations and reduce the funds in circulation. This removal of excess liquidity by RBI is called sterilization.
A working group submitted its report on Instruments of Sterilization on December 02, 2003
Reserve Bank of India - Reports
The report talks about different methods to sterilize or absorb this liquidity or inflows. They have been have been discussed in following posts: