Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Government cash management and liquidity squeezes

India witnesses predictable periodic liquidity squeezes due to large outflows of money from the banking system around the dates on which advance tax instalments are due to the government. The central bank does take some offsetting action to pump liquidity into the banking system, but these actions are often not quite adequate. Sometimes, the liquidity situation is fully restored only as the government starts spending out of the tax receipts. In India, we have gotten used to this as if this is the natural and unavoidable state of affairs.

It was therefore interesting to read a nice paper from the New York Federal Reserve describing how the US has solved this problem completely. The paper by Paul J. Santoro is about the evolution of treasury cash management during the financial crisis, but it is description of the pre-crisis system that is of interest for the advance tax problem. The US Treasury’s cash balance is also “highly volatile: between January 1, 2006, and December 31, 2010, it varied from as little as $3.1 billion to as much as $188.6 billion”. But this volatility does not create any problem either for the banking system or the central bank.

The Treasury divides its cash balance between two types of accounts: a Treasury General Account (TGA) at the Federal Reserve and Treasury Tax and Loan Note accounts (TT&L accounts) at private depository institutions.

If, in the pre-crisis regime, the Treasury had deposited all of its receipts in the TGA as soon as they came in, and if it had held the funds in the TGA until they were disbursed, the supply of reserves available to the banking system – and hence the overnight federal funds rate – would have exhibited undesirable volatility. To dampen the volatility, the Fed would have had to conduct frequent and large-scale open market operations, draining reserves when TGA balances were declining and adding reserves when TGA balances were rising. A more efficient strategy, and the one used by the Treasury in its Tax and Loan program, was to seek to maintain a stable TGA balance.

Each morning Treasury cash managers and analysts at the Federal Reserve Bank of New York estimated the current day’s receipts and disbursements. During a telephone conference call at 9 a.m., they combined the estimates with the previous day’s closing TGA balance, scheduled payments of principal and interest, scheduled proceeds from sales of new securities, and other similar items to produce an estimate of the current day’s closing balance. If the estimated closing balance exceeded the target, the Treasury would invest the excess at investor institutions that had sufficient free collateral and room under their balance limits to accept additional funds. If the estimated balance was below target, the Treasury would call for funds from retainer and investor institutions to make up the shortfall.

The key role in this system is played by retainer and investor institutions with whom the Treasury maintains its TT&L balances. The Santoro paper describes their role as follows:

A retainer institution also accepted tax payments but, subject to a limit specified by the institution and pledge of sufficient collateral, retained the payments in an interest-bearing “Main Account” until called for by the Treasury. If a Main Account balance exceeded the institution’s limit, or if it exceeded the collateral value of the assets pledged by the institution, the excess was transferred promptly to the TGA.

An investor institution did everything a retainer institution did and, as described below, also accepted direct investments from the Treasury. The investments were credited to the institution’s Main Account and had to be collateralized.

During the crisis, as the Fed expanded its balance sheet and banks ended up holding vast excess reserves, the pre-crisis policy of stabilizing the TGA balance ceased to be relevant. Moreover, with the Fed paying interest on excess reserves, depositing money in TT&L accounts would have been an additional subsidy to the banks. Therefore, the Treasury moved to a policy of keeping almost all its cash in the TGA (allowing it to become volatile). As and when monetary policy normalizes, the pre-crisis system will probably come back:

Nevertheless, a significant decline in excess reserves resulting from a shift in monetary policy may once again make it necessary to target a more stable TGA, so that TGA volatility does not cause undesirable federal funds rate volatility and interfere with the implementation of monetary policy.

In short, the advance tax related liquidity squeezes in India is simply the outcome of faulty government cash management practices. Other countries have solved this problem long ago (the late 1970s in the case of the US) and the solution is simple and effective. All that is lacking in India is the willingness to do the sensible thing.


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