Surplus liquidity in the system: How it came and how it may go

News: RBI has pushed excess liquidity into the system. Now, exiting this surplus liquidity scenario of ₹8 trillion will be a challenge.

What are the reasons behind surplus liquidity in the system?

To stimulate growth, various tools were used by RBI during pre-Covid and Post Covid phase to push excess liquidity into the system. For instance,

– LTRO (long term repo operations)

– OMO (open market operations)

– TLTRO (targeted long-term repo operations)

– GSAP (government securities acquisition programme)

– RBI’s low repo rate

– A low CRR (cash reserve ratio)

As a consequence, liquidity increased. Almost ₹6-8 trillion of surplus liquidity resides in RBI’s reverse repo window.  But deployment avenues were limited for a variety of reasons.

Why excess liquidity was not utilized?

First, demand was not strong, with low-capacity utilization rates in most sectors (60-69%) holding back investment.

Second, private investment in infrastructure hasn’t yet taken off.

Third, while MSMEs borrowed on the back of the guarantee, the funds were used to repay loans and maintain business rather than for growth.

Fourth, banks were too picky in terms of new customers, as they had just about come to get bad loans off their books.

Finally, the precondition on loan performance as of 1 March 2020 meant that stressed units did not qualify.

Why exiting the surplus liquidity is a challenge for RBI now?

While the RBI has stopped buying GSAP, it does not address the issue of surplus liquidity. Further, it is difficult for RBI to manipulate the reverse repo window tools as of now.

Banks are trying to stop deposits by keeping interest rates low. Although this can ensure that surpluses don’t increase, it doesn’t reduce them either.

Financial markets have not quite reacted positively to surpluses, as government bond yields remain high in relative terms.

What needs to be done to drain excess liquidity?

First, bank credit demand must pick up, with the economy’s investment cycle turning around.

Second, Centre should be borrowing more so that banks automatically channel their surpluses back.

Third, RBI should be going in for some OMO sales to reverse its GSAP effort, so that these securities return to banks.

Source: This post is based on the article “Surplus liquidity in the system: How it came and how it may go” published in Livemint on 16^th Dec 2021.