Liquidity: from tailwinds to headwinds
Since the start of the pandemic, money markets in India have been flush with liquidity. Average surplus liquidity had averaged around ₹2.8tn from mid-February through late March last year. From April last year through early December, this year surplus liquidity has almost doubled, averaging just under ₹5.5tn.
Two factors were primarily responsible for this surplus liquidity. The first (and the primary) was excess capital flows relative to the trade deficit. India’s trade deficit declined sharply as imports fell more than exports while capital flows remained robust. This enabled the RBI to mop up the excess flows releasing domestic liquidity. Between April-2020 and October-2021, the RBI mopped up almost US$110bn (4% of India’s GDP) of flows from the FX market. The flipside of RBI’s FX intervention was the release of commensurate rupee liquidity in the domestic markets.
The second factor was the mismatch between credit and deposit growth with deposit growth being consistently higher than credit growth. In the first quarter of the calendar year 2020, deposit growth was running ~250bps higher than credit growth. Through FY21 however deposit growth averaged 500bps higher than credit growth and till November this year, deposit growth has been 400bps higher than credit growth. And while Banks have cut lending rates and the RBI and the Government has pushed Banks to lend, credit demand has been anaemic. Consequently, the Credit-Deposit ratio of Banks has fallen to a decadal low of 70% (excluding the demonetisation period). There is thus a lot of slack that has got built into the Banking system.
Of course, the RBI’s accommodative monetary policy stance allowed this surplus liquidity to persist. If the RBI did not have an accommodative stance, this excess liquidity would have got sterilised or rates would have had to increase. And while the monetary policy stance remains accommodative, the factors driving the excess liquidity have turned.
While capital flows remain strong, India’s trade deficit has risen sharply. In the three months ending November-2021, India’s merchandise trade deficit has averaged over US$20bn, the highest ever. At the current run rate, India’s full-year FY22 merchandise trade deficit will be above US$190bn, an all-time high. Accordingly, the strong capital flows are being absorbed by the trade deficit little practically nothing for the RBI to absorb and release domestic liquidity. Thus, India’s FX reserves have stopped rising –they have declined modestly after peaking in early September.
Similarly, the gap between credit growth and deposit growth has narrowed. While deposits are still growing faster than credit growth the gap between the two at just 2ppt as of early December is the smallest since March-2020. On one hand, credit growth has picked up – as of early December credit growth was 7.3% YoY, the highest since January-2020 – while deposit growth has moderated. Worth noting in this context is the recent increase in base rate by SBI (see here).
Given that RBI’s monetary policy stance remains accommodative, it can substitute these two drivers of liquidity through tools of its own – such as the OMOs. But the changing liquidity environment suggests both improving domestic growth (pick up in credit growth and import growth) as well as rising risks (record trade deficit). Given this, the RBI ought to be less willing to accommodate surplus liquidity sloshing around the system. Thus, the period of extraordinarily easy monetary policy in India is most likely coming to an end – the only question is the over the pace of normalisation and the risks resulting from a faster or slower than warranted normalisation.
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