The Hindu Business Line : Liquidity is not the issue

Going by the pronouncements of everyone from the Finance Minister downwards, it is the number one problem affecting the economy and financial system today.

But, what exactly is liquidity? Surprisingly, it can mean different things to different people. Unless this much bandied about word connotes the same thing to all, it is confusing to use it in a generic sense.

Yet that is what is happening. When the Finance Minsiter speaks of making available sufficient liquidity to the economy, he is obviously referring to banks being able and willing to lend money.

That is possible only if they have surplus funds from deposit growth or the Reserve Bank of India’ss liquidity augmenting actions.

Several dimensions

Cut to the chairman of a bank. For him, liquidity has several dimensions.

If the bank is overlent, it is perennially short of money and forced to borrow from the inter-bank market. Asset-liability mismatches also cause liquidity shortages. Non-performing assets affect liquidity (as well as solvency). Yet another facet is the difficulty in selling less-traded bonds, which makes an otherwise first class balance sheet asset illiquid.

Revert to the Finance Minster’s concern about system liquidity.

Alarm bells were raised in October when overnight inter-bank rates rose to the high teens and beyond.

The RBI was quick to slash the Cash Reserve Ratio (CRR) to 5.5 per cent from 8 per cent, releasing almost Rs 100,000 crore of interest-free blocked funds of banks. Opening special borrowing windows and repo lines also helped.

Dramatic effect

The measures have had a dramatic effect. Inter-bank rates are now in control and in the vicinity of the lower end of the LAF corridor of 6 per cent to 7.5 per cent. From borrowers, banks have turned lenders to the RBI.

Banks have also turned on the credit spigots (in contrast to the US where they are simply keeping their funds idle with the Fed). So they are not strapped for funds.

Cut now to the corporate sector. It presents a different picture.

The economic slowdown is assuming serious proportions. Inventories are not turning to cash because final sales are falling. Bank credit is financing inventory accumulation. It is not a good sign.

The issue, therefore, is not liquidity, which the government and the RBI can release at will, but how to get creditworthy consumers and businesses to spend and invest. No one’s sure of the future.

And those with the highest marginal propensity to invest and spend are, unfortunately, already overleveraged - the FCCB repayment obligations alone of corporates is staggering and points to a sharp drain of forex reserves in the months ahead, not of speak of the repayments themselves having to come out of loans - with little spare borrowing capacity.

The first step to tackling the crisis is to correctly understand it.

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