In recent months, you may have often read this: Indian banks are grappling with liquidity challenges. Indeed. But what exactly is banking liquidity and why is this important for the economy and markets?
When discussing banking system liquidity, the most relevant measures is M0 (Reserve Money) and M3 (Broad Money), depending on the context:
1. M0 (Reserve money) – This includes currency in circulation, bankers' deposits with the Reserve Bank of India, and other reserves. It is the most liquid form of money and directly impacts banking system liquidity. The RBI controls liquidity mainly through M0 by conducting operations like repo, reverse repo, cash reserve ratio (CRR) adjustments, and open market operations (OMOs).
2. M3 (Broad money) – This is the most commonly used measure for overall liquidity in the economy and includes M1 (cash + demand deposits) plus time deposits with banks. A liquidity crunch in the banking system often refers to a shortage in M3 growth due to tight monetary policy or high credit demand.
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For short-term liquidity issues, we typically look at M0 because it reflects immediate cash availability in the banking system. The liquidity deficit/surplus that the RBI monitors is based on net banking reserves, a component of M0. However, M3 is useful for gauging the broader impact on money supply and credit availability. Now, why has banking liquidity been tight? There are three major reasons.
3. RBI's Forex interventions: The RBI’s interventions in the foreign exchange market to stabilise the rupee have further tightened liquidity. Every time the RBI sells dollars, it soaks up rupees which tightens the rupee’s supply in the domestic banking system. In other words, the RBI’s forex interventions directly impact banking rupee liquidity, and this has been one of the biggest drains on liquidity in recent times.
4. Advance tax payments: Every time corporates pay advance taxes to the government, it creates a lumpy flow out of the banking system, but briefly. Recent advance tax outflows have significantly reduced liquidity. This tax outgo returns to the system by way of government spending and there could be considerable lag between tax outgo and spending.
5. Cash withdrawals: Increased cash withdrawals during the festive season have also contributed to the liquidity deficit. As people withdraw cash, the funds within the banking system reduce as it drains out cash from deposits, current or savings or even term.
As of last month, the liquidity deficit in India's banking system reached approximately Rs 1.5 trillion ($17.7 billion), marking the highest shortfall in nearly six months.
In response, the RBI has implemented several measures to manage liquidity:
a) Open market operations (OMOs): The RBI announced bond purchase auctions totalling Rs 60,000 crore in three tranches on January 30, February 13, and February 20, 2025.
b) Variable rate repo auction: A 56-day Variable Rate Repo auction for ₹50,000 crore was conducted on February 7, 2025, to provide short-term liquidity to banks.
c) USD/INR Buy/Sell swap auction: On January 31, 2025, the RBI conducted a USD/INR buy/sell swap auction of $5 billion to inject liquidity.
In today’s MPC, the RBI did not announce additional liquidity-boosting measures as part of the latest monetary policy. This is because increasing liquidity in the banking system could stoke inflation when it is just about coming closer to the targeted range. So what is the impact of this? Tight liquidity essentially means the availability of funds is low which means the price of funds will go up. Therefore, even though the RBI has reduced its policy rate, as borrowers of funds from the central bank, banks will continue to feel the pinch. Simply put, the cost of money won’t go down sharply since availability is the issue and this would make banks reluctant to lend to the economy.
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