India and It’s Liquidity Management

India is a rich and diverse nation with 17.7% of world’s population, we can easily gauge the difficulty in managing the whole economy in general and liquidity management in particular. To efficiently manage the economy and money supply we have Reserve Bank Of India(RBI). RBI is India’s central bank, which controls the issue and supply of the Indian rupee.
All the money issued by the central bank is its monetary liability, i.e., the central bank is obliged to back the currency with assets of equal value, to enhance public confidence in paper currency. The objectives are to issue banknotes and give the public adequate supply of the same, to maintain the currency and credit system of the country to utilize it in its best advantage, and to maintain the reserves but –

What is Liquidity?

It is the money available in the banking system. This includes currency and reserves. A liquidity deficit is a cash crunch while a surplus suggests excess of funds. On a daily basis, the central bank, infuses and sucks out funds, responding to the need of the hour — like fund outflows and inflows from the banking system.
RBI uses variety of measures to control the liquidity in the system and various policy statements are issued by RBI frequently to assess the liquidity position of country. The liquidity requirements of any economic system, as the policy statement elaborates, are of two types — temporary and durable.

Short-term or temporary liquidity arises out of temporary mismatches between assets and liabilities and durable liquidity as the name suggest is for longer duration and is mainly tapped through long-term foreign exchange buy/sell swap. In order to meet temporary liquidity, the first recourse for banks is to approach the money market and, in India, the call money market and if it is not adequate then the role of RBI comes into the picture.

It uses various types of repo facilities to meet this liquidity requirement on the other hand there is a need to augment durable liquidity to “facilitate growth and to meet the transaction needs of the economy” and the RBI meets the need of durable liquidity mainly “by modulating the net foreign assets and net domestic assets growth over the course of the year”.

Durable liquidity is very important for an economic system as the repo rate is a short-term rate and for that to get reflected in the long-term rate which is the relevant rate for influencing investment, there has to be an increase in durable liquidity. Repo facility is used for short term liquidity requirement and it cannot substitute the need of long term liquidity requirement. If liquidity is this important then –

How is Liquidity Transferred in the Economy?

RBI conducts open market operations (OMOs) to purchase bonds from market participants via the auction process, a move that infuses money into the system as banks and bond houses receive funds by selling securities it also lends overnight or short-term funds to banks via other borrowing windows like variable repos.

Now, this brings us to our last question –

Is Liquidity Always a Positive?

The answer is straightforward a ‘NO’

Generally, an increase in the money supply (such as the increase generated through the RBI large-scale asset purchases) causes inflation to rise as more money is chasing the same amount of goods and more inflation means ballooning of GDP numbers without any actual increase in employment or productivity.

High liquidity also leads to weakening of domestic currency with respect to international currencies. RBI maintains a delicate balance in demand and supply of liquidity in India and ensures that an optimum level of liquidity is there in the system and in this way it succor Government Of India in managing the development goals as well as the liquidity.

– An article by Manish Kumar, 3rd Year Mechanical Engineering.