Managing Excess Liquidity

Firm's perspective National perspective Global perspective

We started with a tri-dimensional perspective .Now we are zeroing on the national perspective .When we talk about the national perspective ,we are primarily concerned about the liquidity management in Indian Economy .Indian economy is a booming one with amongst the top 5 in terms of GDP on PPP basis and amongst the top 10 when it comes to GDP on the basis of nominal GDP. But still we are amongst the lowest in terms of per capita basis .When we talk in this regard , there are basically two types of policies involved : 1.) Financial Policy 2.) Monetary Policy Fiscal Policy Fiscal policy is employed by government with two main variables playing a pivotal role in this regulation .Government collection (Taxation) and Spending (expenditure).The policy changes in the composition and level of taxation can affect the variables in the economy , namely : a.) Aggregate demand . b.) Allocation of resources c.) Distribution of Income . Fiscal policy is generally employed through the central budget .This is where the decision is made from where one unit of rupee will go and where one rupee will come from.Figure 1 ,2,3,shows () Though we talk of the excess liquidity , but when it comes to indian financial budgets, it is the fiscal deficit (receipts-payments) which has its say .Figure shows the real story of indian fiscal deficit over the years. Monetary Policy

Monetary policy is one of the tools used to control the supply and availability of money, to influence the overall level of economic activity in line with its political objectives. Usually this goal is "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank. It is concerned with the changing the supply of money stock and rate of interest for the purpose of stabilizing the economy by influencing the level of aggregate demand. At times of recession monetary policy involves the adoption of some monetary tools which tends to increase the money supply and lower interest rate so as to stimulate aggregate demand in the economy. At the time of inflation monetary policy seeks to contract aggregate spending by tightening the money supply or raising the rate of return. In short ,it is the process by which the central bank or monetary authority of a country regulates (i) the supply of money (ii) availability of money (iii) cost of money or rate of interest in order to attain a set of objectives oriented towards the growth and stability of the economy. Monetary Policy Instruments Open Market Operations Bank rate Cash Reserve Ratio Statutory Liquidity Ratio Repo rate Reverse Repo rate

OMOs are the means of implementing monetary policy by which a central bank controls the nations money supply by buying and selling government securities, or other financial instruments When the RBI buys bonds from the market and infuses liquidity, the consequences are: It tends to soften the interest rates It enables corporate to borrow at favorable interest rates. It may tend to increase inflation. Consequently If the RBI were to sell bonds instead and suck in liquidity, the effect would exactly be the opposite!! But why this is not preferred ? Because Indian Bill market is not considered to be stable .

Bank Rate The bank rate signals the central bank's long-term outlook on interest rates. If the bank rate moves up, long-term interest rates also tend to move up, and vice-versa. Any increase in Bank rate results in an increase in interest rate charged by Commercial banks which in turn leads to low level of investment and low inflation CRR It refers to the cash which banks have to maintain with RBI as certain percentage of their demand and time liabilities An increase in CRR reduces the cash with commercial banks which results in low supply of currency in the market, higher interest rate and low inflation Currently CRR stands at 4.25% amidst a tussle between the government and RBI with government . SLR

It is the percentage of total deposits commercial banks have to invest in government bonds and other approved securities. RBI in November cut the SLR for banks by one percentage point and it now stands at 24% of their total demand and time deposit liabilities Objectives of SLR To restrict expansion of Bank credit To augment banks investment in government securities To ensure solvency of banks Repo rate If the RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate. Reverse repo Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo signifies the rate at which liquidity is injected Importance of repo and reverse repo It helps borrower to raise funds at better rates An SLR surplus and CRR deficit bank can use the Repo deals as a convenient way of adjusting SLR/CRR positions simultaneously. RBI uses Repo and Reverse repo as instruments for liquidity adjustment in the system

Reverse Repo is undertaken to earn additional income on idle cash.

Major players in repo and reverse repo market The major players in the repo and reverse repurchase market tend to be banks who have substantially huge portfolios of government securities as approved by RBI (Treasury Bills, Central/State Government securities). Besides these players, primary dealers who often hold large inventories of tradable government securities are also active players in the repo and reverse repo market. DFHI is very active in the Repo Market. It has been selling and purchasing on repo basis T-Bills and eligible dated Government Securities.

Call rate is the interest rate paid by the banks for lending and borrowing for daily fund requirement. Since banks need funds on a daily basis, they lend to and borrow from other banks according to their daily or short-term requirements on a regular basis. Liquid adjustment facility A tool used in monetary policy that allows banks to borrow money through repurchase agreements. This arrangement allows banks to respond to liquidity pressures and is used by RBI to assure basic stability in the financial markets. Liquidity adjustment facilities are used to aid banks in resolving any short-term cash shortages during periods of economic instability or from any other form of stress caused by forces beyond their control. banks use eligible securities as collateral through a repo agreement and use the funds to alleviate their short-term requirements, thus remaining stable. Some key features of LAF: Objective : The funds under LAF are used by the banks for their day-to-day mismatches in liquidity. Tenor :Under the scheme, Reverse Repo auctions (for absorption of liquidity) and Repo auctions (for injection of liquidity) are conducted on a daily basis (except Saturdays). Eligibility : All commercial banks (except RRBs) and PDs having current account and SGL account with RBI. Minimum bid Size : Rs. 5 cr and in multiple of Rs.5 cr Eligible securities: Repos and Reverse Repos in transferable Central Govt. dated securities and treasury bills.

Figure 1: Expected Sinks of a rupee

Figure 2: Expected Sources of Rupee Source: Press Information Bureau ,Government of India

Source: business.gov.in

Source: Understanding Inflation by Kaushik Basu ,Chief economic advisor, Ministry of Finance ,GOI