Relationship between Liquidity and Money in India: A Primer

A.K. Mitra and Abhilasha of RBI write this phenomenal and much need paper on the topic. It should be made compulsory reading for all students interested in banking/finance.

The topic of the post and paper may be exotic but the paper is what it says – a primer. Most of the time econs dupe you into reading their paper by calling it a primer. This one truly is.

It explains very neatly about this flow of funds between RBI and banks which is broadly also called as liquidity.

It explains how this liquidity changes under various situations:

  • When RBI conducts Open Market Operations (both buy and sell of government securities),
  • When Cash Reserve Ratio is changed (increase or decrease)
  • When Government expenditure rises
  • Impact of capital inflows/outflows etc

And so on. All this is explained via a very simple format – Changes in RBI (and banks) balance sheet. So you know what really happens on the ground and it is not just superficial stuff.

This bit on whether CRR or OMO is pretty good. There is always discussion on whether RBI should increase (decrease) reserve money via OMO or via CRR. They say both ahve +ves and -ves:

CRR is a tax on the banking system. While CRR balances do not yield any return, the opportunity cost of holding CRR balances is the LAF repo rate in a deficit liquidity mode as banks fund the demand for statutory reserves by borrowings from the LAF window. A CRR cut, therefore, instantaneously improves bank profitability/cost of funding. Banks can pass on the lower cost on their liabilities to their customers by lowering their lending rates (base rate or spread over base rate or both). The higher the prevailing LAF repo rate, higher is the beneficial effect of a CRR cut on bank balance sheets and thus, their ability to reduce lending rates and stimulate credit demand. Even if the LAF continues to remain in a deficit mode following the CRR cut, the government securities freed from LAF can be re-used for accessing liquidity under LAF giving a kick-start to the credit creation process. CRR may also be the preferred instrument when a sizeable amount of liquidity needs to be injected at one go.

Being a blunt instrument, however, the CRR cut equally applies to all banks – depending on their NDTL size – and is independent of the demand for credit. CRR is, therefore, a passive tool and a reduction in CRR while creating the enabling environment for an increase in credit is not a sufficient condition. The success of CRR cut, therefore, depends on the existence of a pent-up demand for credit. If liquidity is already in a surplus mode in the absence of credit demand as was witnessed during the immediate post-crisis period, a cut in CRR would merely cause the freed reserves to be invested in the LAF reverse repo with the Reserve Bank and would not push into motion the money multiplier process.

The participation in OMO by banks usually implies a revealed preference for liquidity to lend and generate a higher risk-adjusted rate of return vis-a-vis the yield-to-maturity on securities sold to the Reserve Bank under OMO. OMO is, therefore, a more efficient tool of liquidity injection. The extant accounting principles for classification of investment portfolio of banks, and the availability of excess SLR with individual banks can, however, constrain OMO participation of some banks.

From the banks’ perspective, the difference between availing liquidity through OMO and LAF is mainly in terms of the duration of liquidity that becomes available; thus, OMO frees the banks from refinancing risks in a rising interest rate environment. OMO also enables banks to improve the liquidity of their bond portfolio as they can substitute illiquid off-the-run securities in OMO with liquid on-the-run securities in primary market issuances by the government. In a falling interest rate environment, however, the incentive of banks for OMO may be somewhat less as banks may miss out on future capital gains; banks can also fund credit by accessing LAF repo at an increasingly lower rate. In the presence of an uncertain interest rate cycle, however, accessing funds through LAF can have financial stability implications.

Hence, keeping in view the state of the economy, the market micro-structure and the regulatory environment, both CRR and OMO are complementary tools of durable primary liquidity injection.

They also have a nice  discussion on whether money matters to monetary policy or not.

Overall a much needed paper from RBI. This one was clearly needed and will help all the students/freshers who join the arcane world of banking.

Once this paper is clear reading my reports on RBI’s WSS is much easier. Infact if this paper was available before, my reports would have been much better.


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