With Rs 4.8 trillion of excess funds flooding the system, the RBI shifted its policy focus to liquidity management by raising reverse repo rate by 25 bps and slashing MSF by an equal measure. In its First Bi-Monthly Monetary Policy on 6th April 2017 RBI stressed upon the "Liquidity Management".
The central bank also promised to have a more effective liquidity management tool in a new instrument called a Standing deposit facility (SDF) at the earliest.
It is therefore essential for a common man to know what is meant by Liquidity Management. It is our endeavour to make common man understand about Liquidity and Liquidity Management.
Liquidity: Liquidity Means available cash in the economic system, be it neutral, deficient or surplus. Availability of the higher amount of cash in the system leads to lowering/softening of the interest rates, whereas deficiency of cash may lead to higher interest rates even without the RBI intervention. Similarly availability of the liquidity in the system influences RBI policy action either through increase or reduction in the policy rates.
RBI's Apprehensions : The banking system had excess cash. In March, the average liquidity was about Rs 4.81 lakh crore, which was conducive to lower overnight rates. In fact, inter-bank call money rate dipped about 65 bps lower than the policy or repo rate at 6.25%. This was clearly not in RBI's comfort zone and could well upset its policy stance. RBI likes to have overnight rates within 15-25 bps range over the policy rate. The central bank changed its policy stance to `'neutral'' from “accommodative“. A neutral stance is contrary to surging liquidity in the system.
Reasons for Excessive Liquidity: The Government's move of demonitisation by banning Rs 500 and Rs 1000 SBN's wef 8th Nov 2016 has flooded the economic system with cash and high Bank deposits. Now with the remonitisation the situation has started coming to normalcy.
RBI's Tools for Sucking Excess Liquidity from the system: With the remonitisation drive of the Government after 31st December 2016 and RBI to print new Currencies and the removal of cash withdrawal limits the excess cash from the system is being withdrawn. This is yielding positive results in addition to the traditional tools such as Open market operations, Cash Management Bills (CMB) and reverse repo auctions.
Impact of Narrowing of LAF Corridor by increasing Reverse Repo rate: By increasing the reverse repo rate the RBI has curbed volatility. This will help short term rates to increase thereby bringing them in line with the policy rates. We expect the short term bonds to outperform long term bonds. Short term bonds are less sensitive to the policy outlook as well as to global risks. In the past few days the policy move has yielded positive results in raising overnight rates.
Liquidity vs Inflation: Since the Economic System which is having excess liquidity is prone to Inflationary tendency. Since RBI's prime objective is to control Inflation RBI focuses on the Management of Liquidity in the system. RBI Governor Mr. Urjit Patel said liquidity management has become important now to contain inflation
Source: Economic Times, Business Line