Concept of Liquidity
Liquidity is a term used frequently in fixed income investing. Investors talk about easy liquidity and
tight liquidity and the impact of liquidity conditions on the yields of fixed income securities. On a
thumb rule basis, easy liquidity brings down yields on fixed income securities while tight liquidity
takes up yields on fixed income securities. What is the liquidity that affects bond yields?
In Indian fixed income markets, liquidity is defined as the bids for reverse repo and repo in the LAF
(Liquidity Adjustment Facility) auction, Term repo auction, Marginal Standing Facility (MSF) held by
the RBI. The banking system has to maintain a cash balance with the RBI. The cash balance to be
maintained with the RBI depends on the CRR (Cash Reserve Ratio). The CRR is fixed at a certain rate
depending on RBI’s monetary policy stance. CRR at present is 4.00% of NDTL (Net Demand and Time
Liabilities) of banks. NDTL forms the aggregate deposits of banks. Hence for every Rs 100 collected
as deposits, banks have to park with RBI Rs 4.00 as CRR.
Banks can have more cash than required to maintain CRR or less cash than required to maintain
CRR. If banks have more cash than required to maintain CRR, banks have surplus liquidity and part
of this surplus liquidity is lent to the RBI at the reverse repo rate. When banks consistently lend
money to the RBI at the reverse repo rate through the LAF auction, the system is said to have surplus
liquidity or liquidity conditions are said to be easy.
Banks can have less cash than required to maintain CRR. Banks, when they have less cash than
required to maintain CRR, borrow funds from the RBI at the repo rate. When banks consistently
borrow funds from the RBI to maintain CRR, the system is said to have deficit liquidity or liquidity
conditions are said to be tight.
Reverse repo rate is the rate at which RBI borrows money from the banks and repo rate is the rate
at which RBI lends money to the banks. The reverse repo rate is set at 1% below the repo rate. RBI’s
action of borrowing money from the banks is termed as sucking out liquidity from the system and
its action of lending money to the banks is termed as infusing liquidity into the system.
Why Does Liquidity go into a Surplus or Deficit Mode?
Liquidity is affected by many factors and these factors determine the liquidity conditions in the
system. One of the factors of liquidity is CRR. RBI, by raising CRR makes banks keep more cash as
CRR and this tightens liquidity in the system. On the other hand banks have more money to
themselves if RBI lower the CRR leading to surplus liquidity in the system.
RBI’s actions of buying and selling bonds, buying and selling currencies, and accepting bids for repo
and reverse repo in the LAF auction affects liquidity in the system.
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Money coming into the country or going out of the country has an impact on liquidity through RBI
purchase and sale of foreign currency.
Government spending or government hoarding cash affects liquidity. People’s preference for hard
cash too affects liquidity.
Why does liquidity go up and down? What are the factors affecting liquidity and how do these
factors affect liquidity?
RBI Policy Actions
The policy actions of the RBI have a direct impact on liquidity. RBI controls or tries to control the
liquidity in the system through its policy actions. RBI’s monetary stance can be accommodative or
tight. An accommodative stance leads to higher system liquidity while a tight stance leads to lower
system liquidity. Hence RBI’s actions on liquidity are determined by its monetary stance. The tools
of the RBI to manage liquidity are:
Policy rates of CRR and SLR
Policy rates of repo and reverse repo
LAF auctions
OMOs (Open Market Operations)
Currency market intervention
Hikes or reduction in CRR (Cash Reserve Ratio) rates and SLR (Statutory Liquidity Ratio) rates lead
to changes in liquidity. Lower the CRR and SLR, the higher the liquidity in the system and vice versa.
Lower CRR rates releases liquidity into the system, as banks require to maintain lower amounts of
cash with the RBI. Lower SLR rates releases liquidity into the system, as banks require to hold less
government bonds. On the other hand higher CRR and SLR rates reduces system liquidity as banks
have to maintain more cash balances with the RBI and they have to buy more government bonds
to hold.
Lower repo and reverse repo rates increases liquidity in the system as banks will borrow more from
the RBI or lend lower amounts to the RBI. Lower repo and reverse repo rates allow banks to lower
its lending rates leading to higher demand for credit from borrowers. Higher credit growth leads to
more deposits for banks (the concept of money multiplier will be studied later). Higher repo and
reverse repo rates reduces liquidity in the system as banks borrow less from the RBI or lend more
to the RBI. Credit demand will go down on higher borrowing costs leading to lower deposits for
banks.
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Banks borrow and lend money to the RBI on a daily basis in the LAF (Liquidity Adjustment Facility)
auctions. The RBI adds liquidity into the system by lending to banks and reduces liquidity in the
system by borrowing from banks. RBI by varying the amounts it wants to borrow or lend in the LAF
can reduce or increase system liquidity.
RBI buys and sells government bonds through OMOs (Open Market Operations). RBI buying of
government bonds increases liquidity in the system while RBI selling of government bonds reduces
liquidity in the system.
RBI buys and sells currencies in order to provide stability to the currency markets. RBI buying of US
Dollars and selling of Indian Rupees adds liquidity into the system and the central bank selling of US
Dollars and buying Indian Rupees reduces liquidity in the system.
Capital and Trade Flows
Foreign portfolio flows into the country adds to liquidity in the system if RBI buys USD, as foreign
investors bring in US Dollars to buy Indian assets. Selling of assets by foreign investors lead to
reducing system liquidity if RBI sells USD as foreign investors sell Indian Rupees and buy US Dollars
to take money out of the country. Trade flows affect liquidity when imports are higher than exports
leading to a trade deficit. A trade deficit increases demand for US Dollars in the economy as
importers sell Indian Rupees and buys US Dollars to pay for imports. Trade deficit is partly negated
by flows of invisibles and other such current account flows but usually current account flows are
not enough to negate the trade deficit. Read our tutorial on Current Account Deficit (CAD) to
understand dynamics of the current account flows. Capital flows from FII, FDI, ECB, NRI Deposits
negate the CAD and system liquidity is not affected but if capital flows are not above CAD, RBI has
to dip into foreign exchange reserves to fund the CAD leading to fall in system liquidity.
Government and Public Cash Balance
Cash surplus of the government reduces liquidity in the system as the surplus is taken out of the
system and parked with the RBI. Government running a cash deficit increases liquidity in the system
as the RBI lends money to the government in the form of overdraft. Public wanting to keep more
cash leads to lower system liquidity as banks deposits come down while public keeping less money
and maintaining more deposits leads to higher system liquidity.
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Registered Office: 13/701 NRI Complex, Nerul, Navi Mumbai - 400706. Mobile: +919819770641 E-mail: zephyr@zephyr.org.in