Arvind Chari
If finance, as they say, is the lifeblood of business, liquidity is the lifeblood of financial markets.
Liquidity, as a concept, has many connotations depending on the context of its usage. The commonly used concept of liquidity is the liquidity of an asset. In that, the most common refrain would be the liquidity of an asset in the stock exchanges and bond markets, market liquidity. So for e.g. – the average traded volume and value of a stock or a bond is measure of how liquid is that asset, which will determine the ability of a market player to buy and sell in amounts, without impacting the price of the asset. Therefore, liquidity of the underlying determines the capacity of the trade. For e.g.: large cap equity funds which invest in companies which have higher market liquidity can manage larger AuM (assets under management) as compared to small cap equity funds which invest in companies which have lower market liquidity without materially impacting the stock price. It is the case for government bond funds over corporate bond funds as well.
The other aspect of liquidity is about the company or a financial entity, funding liquidity. The ability of the company to meet its short-term obligations by generating liquidity from its business operations or from its investments. Liquidity thus becomes a crucial element to track, for creditors – like lenders, bond investors, suppliers – in order to do business with counterparty.
Liquidity in the economy is a function of transactions. Often times, you will hear business people complaining, that the market has no liquidity. As transactions in the economy slow down or stop, the circulation of money in the economy slows down and can thus eventually even slow down the economy. Something similar happened during demonetization when cash got deposited in the banking system, the sudden absence of liquidity in the economy, did result in a fall in the number of transactions/trades/business and resulted in the economy slowing down in terms of activity. Another pertinent example, is the current situation in the real estate industry, as buyers refrain/postpone their house purchases, the builder is unable to generate the liquidity by selling the house and raising the cash required to pay his creditors, which impacts the entire value chain, thus resulting in a cascading impact of tighter liquidity, slowdown in construction activity and eventually default on payment obligations.
The other connotation of liquidity is when you hear economists, bankers and or even the government, complaining to the Reserve Bank of India (RBI), that the economy is starved of liquidity. This aspect of liquidity, central bank liquidity, is at the heart of how an economy functions and is the subject of this article.
The RBI operates, manages and controls the flow of liquidity to the banking system, by injecting or absorbing reserves from the banking system. This central bank liquidity happens to be the key element of monetary policy implementation and the focal point of this operation happens to be a term, which you will commonly hear as, system liquidity, or banking system liquidity.
This system liquidity is determined over and above the actual reserves that the banks mandatorily maintain with the RBI, as CRR or the Cash Reserve Ratio, currently at 4 percent of a bank’s Net Demand and Time Liabilities (NDTL). When banks (net) borrow from the RBI on an overnight basis, through a repo transaction, the banking system liquidity is set to be in a deficit. When banks (net) lend to the RBI on an overnight basis, through a Reverse Repo Transaction, the banking system liquidity is set to be in a surplus. This daily operation of repo’s and/or reverse repo’s is known as Liquidity Adjustment Facility (LAF) and the reason the RBI has to do it daily is to ensure that the overnight market borrowing and lending rate is pegged close to its monetary policy rate; which happens to be the repo rate (currently 5.15 percent). Thus, the daily overnight rate in the call money market (a market where only banks and primary dealers are allowed to borrow and lend without collateral), would depend on whether the LAF operation is net repos (system deficit) or net reverse repos (system surplus). Another important aspect guiding that would be the extent of the system deficit or system surplus.
The drivers of banking system liquidity, apart from the CRR, happen to be:
- Changes in the cash balances of government which are held by the RBI
- Changes in the currency in circulation
- Changes due to foreign exchange (FX or forex) operations by the RBI.
Government cash balance changes are frictional in nature and has the most impact on whether the daily system liquidity is in surplus or deficit. When banks pay all the taxes collected on behalf of the government, to the government’s current account with the RBI, the banking system loses liquidity. When the government spends that amount in its normal course of expenditure, the money moves from the RBIs current account to the current account of various banks, which handle government accounts, the banking system gets back the liquidity. The RBI manages this frictional change through LAF operations by injecting liquidity in the former and absorbing liquidity from the banking system in the latter case.
The other two drivers of banking system liquidity tend to be a bit more durable in nature. Currency in Circulation (CIC), is the amount of physical cash with people, so when they withdraw physical cash from the banking system, banking system liquidity falls and vice versa. CIC has a very clear seasonal pattern of when the demand for physical cash increases (before a sowing season as farmers buy seeds etc; or before festive season) and when the physical cash comes back into the system (after farm harvest) and can thus be modelled and managed. The CIC permanently increases as the economy grows (known as the velocity of money) and thus, the liquidity drainage is of durable nature which the RBI then has to permanently provide this liquidity back to the banking system.
Similarly, foreign exchange operations also affect banking system liquidity. When capital inflows increase and if the RBI does want the rupee to appreciate, it intervenes and buys out the excess dollar inflows from the custodian banks through which the forex comes in and in return sells rupees to those banks, thus the banking system liquidity increases. When the RBI does not want the rupee to depreciate due to forex outflows, it buys the rupee from the banks and sells them the dollars, thus draining out banking system (rupee) liquidity. A persistent period of inflows (like the one we saw in 2004-07) or a persistent period of outflows (like the one we saw in 2012-13) can be challenge for the RBI to manage and may thus lead to periods of huge system liquidity surplus or deficit.
In the liquidity management framework that the RBI follows, it assures and ensures that the system liquidity needs/surpluses will be met daily through its LAF operations. For durable liquidity injections, it commonly uses Open Market Operations (OMO purchases), where it buys government bonds from the market against rupees, ensuring that banks get durable rupee liquidity. Recently, it also introduced, FX Swap, where it bought dollars and sold rupees, for a contracted rate and tenor, assuring banks of durable rupee liquidity. In times of durable liquidity surplus, which it wants to absorb, it will conduct OMO sales and/or FX sell rupees–buy dollar swaps.
Both OMOs and FX interventions, depending on the scale of the operation, may have significant impact on the value of the underlying assets, namely government bond yields and dollar/rupee rate, and thus the RBI needs to use them in a calibrated manner without overtly disrupting the normal market demand and supply. Thus when liquidity surplus is in large excess/deficit on a durable basis and the RBI feels constrained in increasing the size of the daily LAF operation, it may change (rarely done nowadays) the CRR or use Cash Management Bills (CMBs), Market Stabilisation Bonds (MSS) to manage the liquidity situation. The RBI also has the flexibility to use longer-term repo or reverse repo operations to manage system liquidity, but the maximum it has done up until now is for a 90 day period.
The RBI’s liquidity management operation framework has undergone significant changes , especially since 2012, when they first adopted the Repo rate as the single operative rate for monetary policy and the weighted average call money rate (WACR) as the benchmark for liquidity management operations. They also formally instituted a ‘Corridor’ within which the reverse repo rate was to be the lower bound and the Marginal Standing Facility (MSF) to be the upper bound of the liquidity management operation. In order to contain the volatility in the overnight rate markets, they also narrowed this corridor from a peak of 200 bps (2 percent) to the current width of 50 bps (0.5 percent). Thus, the repo rate today stands at 5.15 percent; the reverse repo rate at 4.90 percent; and the MSF at 5.4 percent. Technically, as the banks can deposit all surplus liquidity at the end of the day to the RBI at the reverse repo rate and/or borrow emergency liquidity needed at the end of the day at the MSF rate, the overnight call money rates should at best hover in this corridor.
The RBI’s liquidity management framework with further tweaks in 2014 and 2016 has become even more complicated. As of February 11, 2020, the net liquidity absorbed by the RBI (system surplus) was Rs 3,05,135 crore (3.05 lakh crore), but this was done with using three overnight reverse repo operations (at around the reverse repo rate of 4.9 percent) and eight longer tenor reverse repo operations (at around the repo rate of 5.15 percent) totaling Rs 3,23,981 crore. Also despite the liquidity surplus, there was one overnight repo operation and four, 14 day repo operations at around the repo rate, totaling Rs 15,170 crore. There were small amounts borrowed from under MSF as well as the Standing Liquidity Facility.
On the back of these LAF operations, the overnight call money market, the tri-party repo, market repo and corporate bond repo traded a total of Rs 2,44,563 crore (Rs 2.4 lakh crore) on the same day.
As you can notice, this is hugely complicated and is a highly complex way of managing daily liquidity. The aspect of market trading amongst each other and determining the overnight rate rather gets defeated when the RBI conducts so many operations to manage the system liquidity.
The RBI has now proposed to simplify the liquidity management framework by moving away from too many facilities but at the same assuring the markets that all liquidity needs will be fully met at the repo rate with no quantitative restrictions, supported by daily fine tuning operations.
The new framework does not materially change the situation but does have some market implications:
- The 14-day repo or reverse repo operation beginning every reporting Friday as the main tool for liquidity operations – Although, simple in its approach, the efficacy of it will be tested when system liquidity surplus/deficit is not as Today, system is in surplus of ~Rs 3 lakh crore and the ‘accommodative for as long as necessary’ monetary policy stance, suggests to the bankers that excess liquidity will prevail and hence they will park reasonable amounts with the RBI over 14 days. But, when liquidity situation is not so clear and with the bankers having almost no ability to forecast (Government balance, CIC and FX operations), bankers will cease to borrow or lend to the RBI for 14 days and will resort to the daily fine tuning operations to manage their daily liquidity. Thereby, defeating this effort of simplification.
- Discretionary daily fine tuning operations – Although, conducting this is on RBIs discretion, but even now, given the two aspects below, they will not have much options but to keep conducting fine tuning operations. It may be lesser than what they do now, but it will not be as simple as they desire it to be.A) Assurance to meet all liquidity needs of the system and
B) The need to keep the weighted average call rate (WACR) near the operative monetary policy repo rate.
- WACR as the operative benchmark rate for efficacy – Since the call money market is the only market where only banks can trade ‘reserves’ with each other, it makes sense to target the WACR for liquidity management operations. But the RBI needs to be vigilant, as especially during times of liquidity stress, the WACR may continue to remain close to the Repo Rate, given RBIs LAF operations, but the other money market rates like Treasury Bills, CD (Certificate of Deposit), CP (Commercial Paper) rates might increase displaying the actual reflection of the liquidity deficit as viewed by market participants. The RBI has been found wanting earlier in proactively addressing the liquidity deficit, by focusing only on WACR and reacting late to the increasing spreads on market money market instruments.
- In this new framework, the RBI will not be averse to see the overnight money market rates fluctuate between the Reverse Repo and Repo Rate. Although, we see that even today, but in this new framework, entities who can forecast system liquidity, may be better placed in managing their daily liquidity operations. The spread may not be large, but in today’s low rates, even a 10 bps extra gain on overnight deployment might make a difference in overnight fund and liquid fund returns.
- The Corridor system works best when the system liquidity is in a small deficit. The RBI in April 2016 moved to a framework where it said it will keep system liquidity neutral, to a situation now where it is in deep surplus. Communicating clearly, on how and when the liquidity will move back to neutral will be crucial for banks and the money markets in particular. The current surplus liquidity has led to a massive drop in yields of treasury bills, bank CDs and even CPs of good quality corporates. Money market rates tend to be very sensitive to even small changes in perceived durable liquidity and /or perceived shifts in liquidity management stance of the RBI.
- LTRO – Long Term Repo Operations - The LTRO provides the banks with durable money (1 lakh crore), over a defined tenor (1 year and 3 years) and at a pre-defined rate (5.15 percent). But with LTRO being over and above the existing excess liquidity situation, though voluntary, is essentially a tool to force monetary transmission through stealth. LTRO, if nothing, will at least aid in getting short term bond yields down across the government and corporate credit curve.
Liquidity as you can see has many connotations and the conduct and management of it is complex to the outsider. Sometimes, it is complex even for the RBI itself. Banking System liquidity, as you can understand now, does have huge implications on the conduct of monetary policy and on the current holy grail of ‘monetary transmission’.
With the current surplus liquidity driven by OMO purchases, FX swaps and now LTRO, the RBI has ensured that money market rates and short term bond yields have fallen quite drastically. We will also see sharper fall in deposit and lending rates in the coming months as the impact of the surplus liquidity feeds through onto banks’ balance sheet.
We know from academic history that a central bank cannot solve a solvency/confidence issue with rate cuts or liquidity infusions and we also know that excess liquidity (at low rates) does engender risk taking the impact of which may be seen in the later years.
Arvind Chari is the head of fixed income and alternatives at Quantum Advisors Pvt Ltd. Views are personal.
Discover the latest Business News, Sensex, and Nifty updates. Obtain Personal Finance insights, tax queries, and expert opinions on Moneycontrol or download the Moneycontrol App to stay updated!
