The government's hefty cash holdings, now parked at the RBI, may soon be deposited at commercial banks, a move that would add liquidity to the banking system and make monetary policy more effective by making it easier for banks to cut lending rates.
New Delhi had one trillion rupees held at the Reserve Bank of India at the end of last month, outside of circulation, and roughly twice the amount normally held there as it cut back spending in order to contain its fiscal deficit.
Keeping that much money out of the banking system has created a liquidity deficit that has forced banks to borrow as much as 1.6 trillion rupees from the central bank to meet daily funding needs.
Such a high level of borrowing is far above the RBI's comfort zone of 600 billion rupees, forcing the central bank to buy bonds and pump money into the banking system through open market operations.
Sources with direct knowledge of the matter said Finance Minister P. Chidambaram will soon decide on whether to auction government cash balances now held by the RBI to commercial banks.
"This will help better manage bank liquidity. Also, the government stands to get better returns," an official with direct knowledge of the matter said, declining to be identified because he was not authorised to speak with the media.
Currently the government keeps all its cash surplus with the RBI.
Shifting cash holdings to commercial banks could also ease yields on interest rate swaps, traders said.
"If the government's surplus funds come to banks in the form of short-term deposits, it will bring down lending rates," said M. Narendra, chairman and managing director of Indian Overseas Bank, a state-run lender.
"Since banks get only overnight money from the RBI now through LAF (liquidity adjustment facility), a longer than one-day deposit will provide some stability to banks to deploy these funds for credit and manage liquidity better," Narendra said.
Two years ago, an RBI panel proposed to auction government cash balances to banks for better liquidity management. However, the finance ministry had been reluctant to make public the government's exact cash position, which it says is classified information.
"It seems that there is a gradual softening of stance on keeping the money with banks instead of RBI. Earlier there was some resistance," said another official with direct knowledge Of the matter, also declining to be named.
The first official added that there was no disagreement among senior finance ministry and RBI officials in recent meetings held on auctioning the government's cash balance.
The RBI and the finance ministry did not respond to requests for comment.
Banks have faced cash shortages from time to time because government spending has been unpredictable, driving up short-term deposit rates and preventing most lenders from lowering their base lending rates despite the RBI's 50 basis points of cuts in the policy repo rate this year.
In recent months, Chidambaram has kept government spending on a tight leash in order to bring down a high fiscal deficit, which had put India's investment grade credit rating in peril last year.
To encourage banks to cut rates, the RBI has cut the cash reserve ratio, the proportion of deposits banks need to keep with it, by a combined 200 basis points to 4 percent since January 2012, the lowest since 1976.
It also pumped in 1.32 trillion rupees into the banking system through open market operations in the fiscal year that ended in March, largely to offset the impact of delayed government spending.
Details of how the government's cash would be auctioned to banks are still to be worked out, the sources said.
The central bank would be at liberty to choose the amount of cash balances to be auctioned, and the method to determine the rates is still open for discussion, the official added. It would be up to banks to decide whether or not to bid for the business.