Liquidity conditions for banks will improve on government spending, sustained positive portfolio flows and RBI liquidity infusion actions. However the RBI will have to reassess its bond purchase programs and CRR cuts on the back of liquidity being positive elsewhere apart from the banking system. The central bank may have to formulate other ways to bring about stability in system liquidity as causes of temporary tightness in liquidity is not a reason to use more long lasting tools such as CRR cuts and bond purchases.
RBI’s one wish for 2013 will be to have the right tools to tame the liquidity beast.  Liquidity has been an issue with the central bank in 2012 with banks borrowing around Rs 140,000 crores on a daily average basis (as of week ended 28th December 2012) from the RBI to meet its daily liquidity requirements.
The banks borrowing from the RBI has increased from levels of Rs 90,000 crores seen in April 2012 and this increase is despite the Rs 144,000 crores of money pumped in by the RBI through bond purchases and CRR (Cash Reserve Ratio) cuts. RBI has bought bonds for around Rs 110,000 crores in the April-December 2012 period and has infused Rs 34,000 crores into the system by reducing CRR by 50bps in the same period. RBI liquidity boosting efforts have not yielded results as banks are still in liquidity deficit.
Liquidity in the system is determined by domestic and external factors. On both the fronts there are no alarming signs of liquidity drain.
Domestic flows
One of the reasons for liquidity tightness is the positive cash balance of the government. The government has parked Rs 90,000 crores with the RBI as of 21st December 2012. The excess cash balance of the government is largely temporary in nature and will come back into the system on spending by the government.
Leakages through money going out of the system in the form of hard currency is another factor that causes liquidity tightness. In the April-December 2012 period, Rs 70,000 crores has gone out of the system through currency leakage. This money may not come back into the system and is seen as a permanent drain on liquidity.
The banking system liquidity tightness is not reflected on mutual fund assets. Mutual funds have seen good inflows into its money market and liquid fund schemes in 2012 with inflows of around Rs 160,000 crores, The liquidity between mutual funds and banks is fungible and ideally inflows in mutual funds should have a positive impact on banking system liquidity
Bank credit growth outstripping bank deposit growth is a liquidity draining factor. The Incremental credit Deposit Ratio (ICDR) of banks is at levels of 79% and this has gone up from levels of 20% seen in the earlier part of fiscal 2013-13. The rising ICDR is a drain on liquidity but again it has not reached alarming proportions yet.
External flows
On the portfolio flow front, FII’s have been heavy investors in equity and debt with investments crossing over USD 18 billion for April-December 2012. FII inflows are liquidity positive and this liquidity should be reflected in banking system liquidity.
Trade deficits are outflow of US Dollars from the system and this is a liquidity negative factor. India’s trade deficit for the April-November 2012 period is USD 129 billion, which is liquidity negative. However the trade deficit is not reflected in a drawdown of foreign exchange reserves as India’s foreign exchange reserves have been steady at USD 295 billion fiscal 2012-13 to date. Trade deficit is negated by portfolio flows, receipts from invisibles, External Commercial Borrowings and FDI flows and that is the reason for stable foreign exchange reserves. Liquidity has not been majorly impacted on the external front.
RBI has sold USD 14 billion in the spot and forward currency market and this has a negative impact on liquidity. However the forward contracts have not matured yet and are not a reason for a liquidity drain in the system.
Are there alternatives to bond purchases?
The fact that liquidity conditions do not appear as tight as it seems, RBI could well be adding to inflationary pressures by buying government bonds, which is also seen as back door deficit financing. Bond purchases cannot be retracted, as bond sales by the RBI will be seen as taking out liquidity at a time when the economy is facing growth issues. Hence RBI needs to think out of the box to reduce temporary liquidity issues caused by factors such as government parking excess funds with the central bank.
One good way infuse liquidity into the system without buying government bonds is to allow banks to borrow overnight money from the RBI to the extent of excess cash levels of the government. Banks can be allowed to dip into their SLR (Statutory Liquidity Ratio) for such purposes. Of course there are many issues to be sorted out in such temporary liquidity tools but it still beats back door deficit financing by a wide margin.
