The concerns over inadequate liquidity in the Indian financial system have risen to a point where the finance minister has appointed a committee to make recommendations on how to handle the situation. The Reserve Bank of India’s (RBI) steps to infuse liquidity by cutting the cash reserve ratio (CRR) by 150 basis points over the last week, following its decision to reduce the statutory liquidity ratio (SLR) by 1 per cent in September, have significantly improved the supply of liquidity. However, the committee needs to look ahead in thinking about the nature of the constraint and possible solutions to it. The problem has arisen from a confluence of three factors. The first and oldest contributor is the peculiar fiscal situation, in which the government is effectively subsidising petroleum products and fertilisers without actually parting with any cash. With specific reference to oil companies, the oil bonds, which are supposed to compensate them for under-recoveries on the subsidised products, have not been issued since December. These companies have no option but to borrow from the banks in order to pay for their crude imports. A similar situation prevails in the fertiliser industry. Without the pressure from these two sectors, the economy may not have faced the liquidity problem that it does.
Meanwhile, two other factors then increased the pressure in recent weeks. First, advance tax collections in September absorbed a significant amount of liquidity as it moved from private to government accounts. This is, of course, a temporary withdrawal and will re-enter the system as the government meets its expenditure commitments over the next few weeks. Then came the large exit of foreign investors, who sold shares and converted the proceeds into foreign exchange in order to take it out of the country. As oil prices decline, some of the pressure is easing, but no one can predict when foreign investors will reverse their positions and bring money back into the country. Until then, the problem will persist and the RBI will have to consider further infusions of liquidity through CRR reductions as well as, possibly, bringing down the SLR a little more.
However, a broad-brush approach to liquidity may not be enough. Different parts of the system are under pressure because liquidity is not flowing evenly through it. A concrete example is the debt market mutual funds, which, in the face of heavy redemption pressure from investors, have no option but to sell assets to raise cash. This carries the risk of contagion because the net asset values of funds come under pressure, and compound the situation. This vicious cycle could be avoided if these funds had recourse to a line of credit, appropriately priced of course. They could use this to meet redemption demands without triggering a downward spiral in asset prices. In sum, the committee would do well to recommend a two-tier approach to the problem. The overall level of liquidity must be raised to accommodate the aggregate demand for it, with a willingness to reverse course as some of the constraints ease off. But, beyond that, the special circumstances of some components of the system must be considered as a basis for more narrowly targeted measures, with the beneficiaries being asked to pay a reasonable price for the service.
