Context: India’s current liquidity deficit is due to various domestic and global factors, affecting deposit growth, credit expansion, exchange rates, and central bank policies.
Relevance of the Topic: Prelims: Key terms related to Liquidity management by RBI.
Liquidity Management in India
- Liquidity management is a key function of the Reserve Bank of India (RBI) that ensures effective monetary policy transmission and smooth financial system operations.
- It involves the central bank's procedures to align short-term interest rates with the policy rate.
- RBI's liquidity management framework involves three key aspects: operating framework, liquidity drivers, and liquidity control mechanisms.
- Since 2011, the fixed overnight repo (repurchase) rate under the Liquidity Adjustment Facility (LAF) has been formally announced as the single monetary policy rate, with the Weighted Average Call Money Rate (WACR) as the operating target of monetary policy.
Importance of Liquidity Management
- Supporting economic growth: By maintaining optimal liquidity, banks can continue lending to businesses and consumers, supporting economic activity and growth.
- Facilitating monetary policy transmission: Effective liquidity management by the RBI helps in the smooth transmission of monetary policy.
- Ensuring financial stability: It helps Indian banks and financial institutions maintain adequate cash reserves and liquid assets to meet short-term obligations and withstand economic shocks.
- Meeting regulatory requirements: RBI has implemented stringent liquidity requirements such as the Liquidity Coverage Ratio (LCR) for banks. Liquidity management is essential for banks to comply with these regulatory norms.
- Managing volatility: Sound liquidity management helps banks and the RBI handle sudden inflows or outflows of foreign capital.
- Building investor and depositor confidence: Strong liquidity positions enhance the credibility of banks among investors and depositors, crucial for maintaining stability.
- Managing currency fluctuations: Liquidity management helps banks handle exchange rate volatility, which is important given India's increasing global financial integration.
Key drivers of Liquidity in the Banking System
- Government cash balances with RBI: The government's higher cash holdings at the RBI reduce system liquidity and lower balances increase it.
- Changes in currency in circulation: An increase in currency in circulation reduces liquidity in the banking system, while a decrease increases liquidity.
- RBI's forex operations: When the RBI buys foreign currency, it injects rupee liquidity into the system, and when it sells foreign currency, it absorbs rupee liquidity.
- RBI's market operations: Through its liquidity tools such as Open Market Operations (OMOs), the RBI can inject liquidity by purchasing government securities or absorb liquidity by selling them.
- Changes in CRR, SLR: An increase in Cash Reserve Ratio (CRR) or Statutory Liquidity Ratio (SLR) requirements reduces liquidity in the banking system, while a decrease increases liquidity.
Factors contributing to current Liquidity Deficit in India
- Mismatch between deposits and credit growth:
- Faster credit expansion compared to deposit growth has created liquidity pressure in the banking system.
- Many investors shifted funds from bank deposits to capital markets, driven by high stock market returns and mutual fund attractiveness.
- Banks were unable to increase deposit interest rates significantly due to the high repo rate (6.5%), which affected their profit margins.
- Impact of government spending:
- Government spending was lower than usual due to the election code of conduct, leading to high cash balances with the RBI instead of commercial banks.
- Payments made to the government reduced bank deposit growth, further tightening liquidity.
- Impact of US economic policies: US government's policies (higher tariffs, tax cuts, and strict immigration rules) have strengthened the US dollar, leading to:
- Depreciation of the Indian rupee and other currencies.
- Increased volatility in Foreign Portfolio Investments (FPIs), as investors factored in currency risks.
- Stock market fluctuations due to adjustments for currency depreciation and inflation.
- RBI's role in managing forex reserves:
- RBI’s forex reserves peaked at $705 billion (Sept 2024) but have now declined to $630–640 billion due to forex interventions.
- RBI’s sale of dollars to stabilize the rupee led to a further liquidity crunch, reducing the money supply in the banking system.
Liquidity Management by RBI
- Changes in RBI's Liquidity framework:
- The 2020 liquidity framework focused on:
- Variable Repo Rate (VRR) and Variable Reverse Repo Rate (VRRR) to manage liquidity.
- Discontinuation of daily overnight repo operations.
- Due to the liquidity crunch, RBI resumed daily overnight repo operations to fine-tune liquidity.
- This was done, while ensuring that the weighted average call rate (WACR) remains stable at around 6.30% (above repo rate of 6.25%).
- The 2020 liquidity framework focused on:
- Anomalies in the banking system:
- RBI is simultaneously injecting liquidity (~₹2 lakh crore through VRR) while banks are parking surplus funds in the Standing Deposit Facility (SDF) at 6% interest.
- Banks prefer SDF deposits over lending in the unsecured call money market, even though the call rate is slightly higher (~6.30%).
- Borrowers are shifting to the tri-party repo market, where borrowing is cheaper against securities like Treasury Bills.
Impact of a volatile Rupee on liquidity
- FPI withdrawals have increased rupee volatility, leading to stock market fluctuations.
- The US dollar index movements significantly affect the rupee’s value, even when US policies do not directly target India.
- RBI's intervention to stabilize the rupee (selling dollars) has further tightened domestic liquidity, requiring more central bank action.
Way Forward
- Domestic policies:
- Banks need to offer higher deposit rates or introduce new savings schemes to boost deposits.
- RBI could diversify its liquidity management tools beyond repo operations.
- Maintaining forex stability is crucial to prevent excessive rupee depreciation.
- Global context:
- India’s trade negotiations with the US (on hold until March 2025) will be crucial in determining future liquidity trends.
- The US-imposed tariff hike could trigger a trade war, affecting Indian exports and overall liquidity.
- Central banks worldwide, including the RBI, need to remain vigilant in FY26 as global trade dynamics evolve.
Key Terms
- Call money rate: rate at which short term funds are borrowed and lent in the money market.
- The duration of the call money loan is 1 day.
- Banks resort to these types of loans to fill the asset liability mismatch, comply with the statutory CRR and SLR requirements and to meet the sudden demand of funds.
- RBI, banks, primary dealers, etc. are the participants of the call money market.
- Demand and supply of liquidity affect the call money rate.
- Tight liquidity conditions lead to a rise in call money rate and vice versa.
- Weighted Average Call Rate (WACR): WACR represents the unsecured segment of the overnight money market and is best reflective of systemic liquidity mismatches at the margin.
- It is explicitly chosen as the operating target of monetary policy in India.
- The operating procedure of monetary policy is guided by the objective of aligning the operating target of monetary policy – the WACR (weighted average call rate) – to the repo rate through active liquidity management, consistent with the stance of monetary policy.
- Once the policy repo rate is announced, liquidity operations are conducted to keep the WACR closely aligned to the repo rate.