Liquidity Longs Leverage Lilt

Liquidity for business entities is when they have sufficient funds or credit limits to meet their obligations. Liquidity for banks is when they have sufficient funds to meet their disbursement, redemption, and reserve ratio obligations. Liquidity for the banking system is when funds are available in the money market for the banks to borrow and lend as per their deficiencies and surpluses of funds.

However, the real liquidity is not when volumes of funds are held by banks or central bank. Liquidity is only when the funds move effectively and timely in the financial system for the effectiveness of monetary policy, transmission of interest rate changes, management of inflation, and economic growth.

If liquidity increases, it indicates availability of money for lending and spending. Excess liquidity pushes down interest rates in the call money market. Banks with surplus do not have incentive to lend to other banks at lower interest rates. Instead, banks tend to lend aggressively and to risky projects. This may create asset bubbles and increases inflation. If liquidity decreases, interest rates in the money market increases and lending rates will also increase. When money market interest rates are higher, banks may have lower margins and therefore may not borrow from money market for their onward incremental lending. This causes credit squeeze in the market and slows down investments, business expansion, consumption, overall lending, and economic growth.

Excess of surplus or deficit in the liquidity is harmful to the financial system. Therefore, central banks regulate the cash in the financial system as per the required liquidity levels. There is no fixed optimum level for liquidity as it changes from time to time depending on the economic activity and flow of money in the market.

Reserve Bank of India (RBI) tracks and measures liquidity in the system through indicators. Movement of funds in Liquidity Adjustment Facility (LAF), level of Net Time and Demand Liabilities (NDTL), Weighted Average Call Rate (WACR), Secured Overnight Rupee Rate (SORR), Credit-Deposit (CD) ratio, etc are the main indicators. Inflation is another indicator. RBI regulates the cash in the system with tools such as Bank rate, Repo rate, Standing Deposit Facility (SDF) rate, Marginal Standing Facility (MSF), Reverse Repo rate, and reserve ratios. The reserve ratio are Cash Reserve Ratio (CRR), Statutory Liquidity Ratio (SLR), and Liquidity Coverage Ratio (LCR).  

Bank rate is the interest rate at which banks can borrow from RBI without any collateral security. Repo rate is the interest rate at which banks can borrow from RBI against collateral securities. SDF offers lower interest rate to banks than repo rate. MSF collects higher interest rate from banks than repo rate. The range between SDF and MSF is termed as corridor. Repo with RBI and market Repo, which are secured borrowing facilities are available from 9 am to 4 pm. Call money market which is an unsecured overnight facility is available from 9 am to 7 pm. SDF is available from 7 pm to 11.59 pm. Bank rate borrowings and MSF borrowings can be made in the hours during the day as specified by RBI.

These timings and the dynamics influence effective movement of funds among the banks at call money rates which are the real market interest rates determined by supply and demand forces. For instance, if banks cannot lend in call money market by 7 pm, which could be mainly due to lack of borrowing interest from other banks, they park the surplus funds with RBI in SDF.

More funds into SDF indicates surplus liquidity in the system. Correspondingly, if more funds are borrowed in MSF window, it indicates liquidity deficit in system. Thus, effectively surplus liquidity implies that banks have more funds than they could lend in the market and liquidity deficit implies that banks have less funds than they need for their operations. The parking of funds and borrowings happen every day. If RBI observes more SDF deposits or more MSF borrowings, RBI may also conduct Open Market Operations (OMO). In OMO, RBI may sell government securities held by it and absorbs liquidity from the market. Correspondingly, RBI may buy government securities from the market infusing liquidity into the market. RBI may also modify its reserve ratios wherein increasing CRR and SLR will reduce liquidity and vice versa.

The present situation in Indian financial system is curious. RBI reduced Repo rate by 100 basis points within 5 months from February to June 2025 which RBI termed as advancing move to facilitate faster growth. The transmission of reduced interest rates in the loans and deposits is still underway. The liquidity in the system is high but June 2025 consumer price index (CPI) inflation is 2.1% which is the lowest in the past 6.5 years. It is axiomatic that earlier projected 6.5% real growth rate of Gross Domestic Product (GDP) should rise as inflation lowered from 4% to 2%. However, the projection of the real growth rate of GDP which is basically nominal growth rate less inflation is retained at 6.5%. This could be a cautious approach by RBI considering certain headwinds including trade tariff risks, geopolitical tensions, CD ratio persisting at 80%, and the projected inflation at 3.1% for full year of 2025-26.

Besides futuristic approach, it is important to track the developments on the other fronts including significantly lower credit growth at 12%, core inflation still above 4%, CRR already lowered to 3%, and the disintermediated short term funding in the market through commercial papers and bonds is increasing.

The key for credit dispensation, inflation, and economic growth lies in movement and leveraging of the funds rather than volumes of funds. In sum, liquidity in financial system is not levels, but is leveraging currency which is the lifeline for the growth.

Disclaimer: Dr. Kishore Nuthalapati is an Economist and a Corporate Finance Professional. Dr. Kishore is serving as the CFO of BEKEM Infra Projects Pvt Ltd, Hyderabad, India. Views are his personal and do not reflect those of any of the organizations he is or was associated with.