Impact of liquidity on various aspects of economy

A very basic definition of liquidity is 'the cash or money in a system'. Liquidity is measured in terms of the monetary base and the Reserve Bank of India (RBI) is the sole supplier of liquidity in the country.

In general, the supply of monetary base by the central bank depends on the public's demand for currency and the banking system's need for reserves to settle or discharge payment obligations.

The RBI monitors the liquidity situation on a daily basis and attempts to control and moderate liquidity conditions by varying the supply of bank reserves to meet its macroeconomic objectives of financial stability.

The periodic liquidity assessment is done by the RBI based on the bank reserves position, and the expected inflows and outflows from both domestic operations and foreign flows. Depending on the liquidity forecast, the RBI decides on a course of action to be taken to either supplement or withdraw liquidity.

These are some of the factors that influence liquidity conditions in the economy: Domestic factors An increase in liquidity is required to cover inflation and GDP growth. Several instantaneous domestic factors also influence the liquidity in the system.

Most commonly, quarterly or annual advance tax payments draw liquidity out of the system as a lot of liquid money gets locked with the government.

On the other hand, any large payouts by the government or higher corporate sector spending can increase the liquidity in the system.

Funds inflows

A strong economic performance and the relative under-performance in the developed countries attracted the attentions of many large global investors who were drawn towards investing here ( FDI as well as portfolio investments).

This resulted in healthy capital inflows in the last few years. These capital inflows put a lot of pressure on the liquidity management here as uncontrolled capital flows can result in rising inflation, currency appreciation, loss of competitiveness and reduction in monetary control.

Tools to control liquidity

The RBI monitors the liquidity situation periodically and takes necessary steps to control the situation from time to time. The RBI uses various direct and indirect policies to control the shortterm and long-term liquidity position.

These are various instruments used by the RBI to control liquidity:

Cash reserve ratio: The RBI uses the cash reserve ratio (CRR) as a tool to control the medium to long-term liquidity issues. An increase in the CRR results in an increase in the amount of money that banks have to maintain with the RBI as a percentage of their deposits.

This reduces the overall liquid funds with the bank and hence reduces the overall liquidity. Liquidity adjustment factor: The liquidity adjustment factor (LAF) was introduced a decade ago as a part of financial reforms.

LAF helps in managing a shortterm liquidity situation resulting from the large and volatile capital flows (inflows as well as outflows). Reverse repo rate: The RBI uses the reverse repo rate for short-term liquidity management and to smoothen interest rates in the call/money market.

The repos also help in keeping the interest rates in a predictable range, as provided by the prevailing repo rate and reverse repo rate.

In times of excess visible liquidity, the call rates hover around the reverse repo rate, whereas in times of tight liquidity, the call rate will hover around the repo rate.

Liquidity impacts inflation

An uncontrolled and unmanaged liquidity situation can have a severe impact on inflation, rates of interest, STOCK MARKETS, and foreign exchange rates.

Since the conditions in the global markets and foreign fund flows are quite volatile, the job of the RBI in controlling the liquidity condition has become more challenging.

The RBI has taken small steps in changing the monetary policy since the beginning of this year. These steps have shown good results in terms of maintaining interest rates, liquidity and GDP growth.

The inflation rate is still ruling high due to various factors and analysts believe that further monetary actions from the RBI along with a good rainfall and base effect will moderate it in the next couple of quarters.