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 0.25% 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.
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.
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.