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The Indian Liquidity Story

Posted in Finance Articles, Total Reads: 2862 , Published on January 28, 2013

We are all familiar with the term liquidity but do we actually understand the depth of the word. Ask anyone and each has his/here own interpretation. Well today based on my knowledge and research I hope to give my understanding of the same. Liquidity can be broadly interpreted as the exchange of financial assets in one form for another between various financial institutions. The liquidity in the financial markets also may take many forms - market liquidity (for asset markets), banking liquidity, and funding liquidity.

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Banking system liquidity

I see that the best way to look at liquidity is from the Central bank’s point of view as shortage of liquidity lies at the heart of a banking crisis. And in today’s uncertain environment measuring systemic liquidity will help ascertain its effects on Banks’ performance. Liquidity is a key factor that drives Indian financial markets and is used by banks and other financial institutions for  trading & making investments. Banking system liquidity influences money market interest rates, and hence it is also important to understand what drives liquidity change.

Measuring liquidity

First we must understand how liquidity is measured to truly understand what it is. The first method of measurement is the Liquidity Adjustment Facility (LAF). LAF is a facility extended by the RBI to the scheduled commercial banks and primary dealers to avail of liquidity in case of requirement or park excess funds with the RBI in case of excess liquidity on an overnight basis against the collateral of Government securities including State Government securities. The operations of LAF are conducted by way of repurchase agreements (repos and reverse repos) with RBI being the counter-party to all the transactions. Some market participants generally consider the LAF number that is released by RBI on a daily basis as a measurement of Liquidity within the banking system.

However the LAF borrowing tends to be volatile and may not give a complete picture of actual liquidity requirements of the system. This is a result of the fortnightly Cash Reserve Requirement (CRR) system which mandates banks to maintain 4.50% of their total net demand and time liabilities for the whole fortnight. However, on a daily basis banks may deposit higher/lower than the required CRR with the RBI. Normally, banks tend to deposit excess CRR during the first week of the reporting fortnight and to adjust for the same they deposit lesser during the second week of the fortnight. A higher CRR outflow leads to outflow from cash from banking system and therefore banks have to borrow more from RBI’s LAF window when they deposit excess CRR. Thus, the second method to measure Liquidity is to adjust the LAF borrowing for the variation in CRR maintenance, referred to as product adjustment. Banks prefer a more stable estimate of Liquidity the volatility of LAF borrowing number makes it hard to understand and predict liquidity.  Thus market participants also adjust the LAF borrowing for product (CRR) to measure liquidity. Product is the actual cash balance maintained on a daily basis by banks with the Reserve bank of India.

Factors that drive liquidity

We also need to look at the factors that affect liquidity and drive changing liquidity conditions. Simply put, we analyze things from the perspective of the banking system. Any outflow of cash from banks to the Government/RBI/ the public will reduce banking system liquidity while any inflow will add to banking system liquidity. These factors include:

  • Government securities and Treasury bill Auctions:

RBI, in consultation with the Government of India, issues an indicative half-yearly auction calendar containing information of the borrowing programme of the Government.

  • Open Market Operations (OMOs)

RBI also conducts OMOs which are market operations involving sale/ purchase of Government securities to/ from the market with an objective to adjust the rupee liquidity conditions in the market on a durable basis.

  • Coupon and redemptions

The coupons are the payment of Interest to holders of dated Government securities, long or short term that may have a fixed or floating coupon. The redemption proceeds are the amount paid to the holders of dated Government securities and Treasury bill at the time of maturity of these instruments.

  • FX intervention

In the Forex markets, the RBI intervenes indirectly via Nationalised banks. In order to prevent rupee volatility, the RBI may sells dollars thus preventing rupee depreciation, however in the process rupee liquidity is sucked out of the system. Sales of dollars (purchase of rupees) is an outflow from banks while purchase of dollars (sale of rupees) is an inflow into banks

  • Tax outflows

In India, advance tax payments flow out from the banking system. Advance tax outflow take place on a quarterly basis after the 15th of September, December, March and June. Excise tax outflows also affect banking system liquidity

  • Cash Reserve Ratio (CRR)change

CRR is that percentage of Scheduled Commercial Banks Net Demand & Time Liabilities (NDTL) maintained with the Reserve Bank of India on a fortnightly basis. The RBI of India is empowered to increase or decrease the said rate which is announced during the Monetary Policy of the Reserve Bank of India.

  • Government spending

Government expenditure for paying salaries, wages, oil subsidies, defence payments, all social grants etc leads to inflow into the banking system from the government.

Thus each of the above factors either contribute to increasing or decreasing banking system liquidity, whether it is an Auction or an OMO buyback or a reduction in CRR or increase in advance tax payments.

Finally we see how liquidity affects market rates. Banking system liquidity plays a key role in determining the overnight money market call rate. If bank liquidity is in surplus i.e. they are depositing excess funds in RBI’s reverse repo window, the call rate in money market will be close to the reverse repo rate of 7%. However, if banks are in deficit i.e. they are borrowing from RBI’s repo facility at 8%, the call rate will be slightly higher than the repo rate. As such, liquidity plays a key role in influencing money market lending and has implications for government bonds, corporate bonds and other term money lending.

This article has been authored by Erica Fernandes K.J. Somaiya Institute of Management Studies & Research.

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