INSUBCONTINENT EXCLUSIVE:
Liquidity is oxygen for a financial system
While the system was gasping for breath around this time last year, today there appears to be too much of it
destroy money (liquidity) is the central bank
And this money grows within the financial system through the money multiplier effect
individuals alike, are linked to this money creation process.
It is no wonder then that the central bank can influence the money creation
process through intervention
From an average liquidity deficit of about Rs 85,000 crore in November, 2018, the system moved to a surplus of Rs 2.51 lakh crore as on Oct
31, 2019, a swing of about Rs 3.36 lakh crore
This is a fairly large swing in liquidity in such a short timeframe.
Of course, we have seen much larger swings in exceptional times such as
the demonetisation exercise and the subsequent remonetisation phase
It conducted open market operations amounting to Rs 2.65 lakh crore since November, 2018 and two foreign exchange swap operations amounting
payment to the central government of about Rs 1,76,100 crore and ad-hoc intervention in the foreign exchange market also added to core
All this in an environment where currency with public increased by about Rs 2,84,600 created a drag on liquidity.
During the same time, the
monetary policy committee also shifted its focus towards reviving growth, cutting repo rates by 135 bps since February, 2019 from 6.50 per
In fact, the rate movement has been 160 bps, considering the financial system has actually been operating at the reverse repo rate, which
currently stands at 4.90 per cent, thanks to the easy prevailing liquidity conditions.
A natural consequence of the above two phenomena has
been a steep reduction in rates across the yield curve, especially at the short end
For example, the one-year private bank CD rates moved from about 8.5 per cent in Nov, 2018 to about 5.90 per cent currently, reflecting not
only cut in policy rate itself, but more importantly a compression in spread between overnight rate and the one-year private bank CD
rates.
A similar phenomenon has been observed across the short end of the yield curve up to the three-year AAA bonds
However, this transmission has been more apparent in the short-term AAA segment of the bond, while being more sluggish in the banking space
MCLRs not moving in tandem.
Transmission of reduced policy rates and easy liquidity into lower lending rates in the banking system has been
In my opinion, an important aspect that has been playing a major part in this has been the liquidity mismatch that the banking system has
been facing through the remonetisation period, where deposit mobilisation was not keeping pace with credit demand for a sustained period of
set on reviving growth and ensuring adequate liquidity in the banking system, it is more probable now that one would see better transmission
of past rate cuts in fresh loans
We have also started seeing bank term deposit rates going down, which signals lower pressure on deposit mobilization.
Such an environment
may pose challenges for traditional savers, as chasing higher yields by taking on credit risk may not be the best way forward, given the
heightened risk perception in the market.
Such investors can instead look to benefit from debt funds that focus on high credit quality and
are positioned at the lower end of the interest rate risk spectrum
This can help mitigate credit risk as well as duration risk.
(Kedar Karnik, Fund Manager, DSP Investment Managers, also contributed to this