Banking system in India is experiencing a notable liquidity deficit

  • November 23, 2023
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Banking system in India is experiencing a notable liquidity deficit

Subject: Economy

Section: External Sector

Context: The banking system in India is experiencing a notable liquidity deficit, reaching a five-year high on November 22.

Several factors contribute to this liquidity squeeze:

  1. GST Outflows:
    • Heavy outflows are attributed to goods and services tax (GST) payments, creating a significant impact on liquidity.
  2. Bond Auctions:
    • Weekly bond auctions have also contributed to the liquidity deficit.
  3. RBI’s Incremental Cash Reserve Ratio (I-CRR):
    • The central bank introduced Incremental Cash Reserve Ratio (I-CRR), which withdrew around Rs 1 lakh crore from the banking system.
  4. Frictional Liquidity Movement:
    • Frictional liquidity has been oscillating between a small surplus and a deficit of as much as Rs 2 lakh crore during the month.
  5. Historical Context:
    • Bloomberg data indicates that the current liquidity deficit is the highest since December 2018.
  6. Kotak Mahindra Bank Report:
    • A report from Kotak Mahindra Bank highlighted expectations of Rs 1.5 lakh crore outflows due to GST and Rs 65,000 crore due to auctions.
  7. Previous Liquidity Dynamics:
    • Before the introduction of I-CRR, liquidity had remained in surplus. Efforts were made to reduce the surplus, but temporary measures were not effective, leading to the implementation of I-CRR.
  8. I-CRR Objective:
    • I-CRR was introduced to address excess surplus liquidity caused by the withdrawal of Rs 2,000-denomination currency notes from circulation.
  9. Timeline of I-CRR Implementation:
    • The central bank phased out I-CRR, releasing 25 percent of the funds on September 9, another 25 percent on September 23, and the remaining 50 percent on October 7.
  10. RBI’s Monetary Measures:
    • The RBI, in conjunction with rate hikes, used tools to tighten liquidity, transitioning from an ultra-surplus situation post-Covid to a deficit. This strategy aims to contain inflation while protecting economic growth.
  11. Expectations for Future Liquidity:
    • The liquidity deficit is expected to ease in the coming days due to inflows from bond redemptions and month-end government spending.
  12. Bond Redemption:
    • Significant bond redemptions are expected, with bonds worth Rs 56,572.719 crore set to redeem on November 25 and Rs 32,500 crore on November 29.
  13. Government Spending:
    • Month-end government spending is anticipated to contribute to the improvement of the liquidity position.

Issues with Incremental Cash Reserve Ratio (I-CRR)

The Reserve Bank of India (RBI) has recently announced the phased discontinuation of the Incremental Cash Reserve Ratio (I-CRR), a measure implemented to manage excess liquidity in the banking system. The central bank plans to release the funds impounded under I-CRR in stages, ensuring a smooth transition and avoiding abrupt shocks to liquidity.

How Will the RBI Implement Discontinuation of I-CRR?

  • The discontinuation of I-CRR will be carried out in stages, with 25% of each bank’s impounded funds released in the first and second stages.
  • The remaining 50% of the balance will be released in the third stage.
  • This phased approach is designed to provide banks with sufficient liquidity to meet increased credit demand, particularly during the upcoming festival season.

What is I-CRR?

Background:

  • The RBI introduced the Incremental Cash Reserve Ratio (I-CRR) on August 10, 2023, following the demonetization of Rs 2000 notes and the announcement of monetary policy.
  • Banks were mandated to maintain an I-CRR of 10% on the increase in their Net Demand and Time Liabilities (NDTL) between May 19 and July 28.
  • The central bank stated its intention to review the measure in September 2023.

 Purpose of Introducing I-CRR:

  • I-CRR was introduced as a temporary measure to manage excess liquidity in the banking system.
  • Factors contributing to surplus liquidity included the demonetization of Rs 2,000 banknotes, RBI’s surplus transfer to the government, increased government spending, and capital inflows.
  • The liquidity surge had the potential to disrupt price stability and financial stability, necessitating effective liquidity management.

Impact of I-CRR on Liquidity Conditions:

  • I-CRR was expected to absorb over Rs 1 lakh crore of excess liquidity from the banking system.
  • The measure temporarily turned the banking system’s liquidity into a deficit on August 21, 2023, exacerbated by outflows related to Goods and Services Tax (GST) and central bank intervention to stabilize the rupee.
  • However, liquidity conditions later returned to surplus.

What is the Cash Reserve Ratio (CRR)?

About:

  • The Cash Reserve Ratio (CRR) is the percentage of cash that banks are required to keep in reserves against their total deposits.
  • All scheduled commercial banks, including Small Finance Banks, Payments Banks, Co-operative Banks, and others, must maintain CRR with the RBI.
  • CRR funds are non-lendable and do not earn interest.

Need to Have Reserve Cash with the RBI:

  • Ensures security of a portion of the bank’s deposits in case of emergencies.
  • Provides readily available cash when customers request their deposits.
  • Helps in controlling inflation by reducing the amount of money available for lending during times of inflationary threats.

Why is RBI Using I-CRR in the Case of Demonetization?

  • The RBI chose to implement I-CRR during events like demonetization to address sudden liquidity influxes precisely and without affecting other aspects of monetary policy.
  • I-CRR can be implemented quickly, making it suitable for addressing liquidity surges during unique situations.
  • It is intended as a temporary measure, absorbing excess liquidity temporarily and phased out once the liquidity situation stabilizes.

Monetary Policy Instruments available with RBI:

Qualitative:

  1. Moral Suasion: Persuasion and communication to influence banks’ behavior.
  2. Direct Credit Controls: Regulating credit flow to specific sectors or industries.
  3. Selective Credit Controls: Targeting specific types of loans to control demand in specific areas.

 Quantitative:

  1. Cash Reserve Ratio (CRR): Reserves against total deposits.
  2. Repo Rate: Interest rate for short-term lending to banks.
  3. Reverse Repo Rate: Interest rate for banks to park excess funds.
  4. Bank Rate: Rate for long-term funds provided to banks.
  5. Open Market Operations (OMOs): Buying or selling government securities.
  6. Liquidity Adjustment Facility (LAF): Includes repo and reverse repo rates.
  7. Marginal Standing Facility (MSF): Overnight funds borrowing against collateral.
  8. Statutory Liquidity Ratio (SLR): Percentage of NDTL to be maintained in approved securities.
Banking system in India is experiencing a notable liquidity deficit economy