Recent developments in India’s banking system have brought into light important challenges. After enjoying surplus recent-liquidity-management-strategies/" target="_blank" rel="noopener">liquidity for over two months, the system faced a sudden decline. The Reserve Bank of India (RBI) intervened by injecting ₹6,956 crore to address the liquidity deficit.
About Liquidity Deficit
Liquidity deficit occurs when the banking system has less cash than required. This recent deficit is linked to a negative balance of payments, amounting to $23 billion. Foreign portfolio investors have been withdrawing funds, prompting the RBI to sell dollars to stabilise the rupee.
Impact on Borrowing Costs
As liquidity tightens, the weighted average call rate (WACR) has risen. It is now 22 basis points above the policy repo rate, reaching 6.72%. This increase raises borrowing costs for banks. Consequently, companies face higher expenses when raising funds through debt instruments like commercial papers.
Core Liquidity Trends
Core liquidity, which includes system liquidity and government surplus, has seen a notable decline. It dropped from ₹4.6 trillion in September to ₹1.6 trillion by mid-November. This reduction signals a potential for ongoing liquidity tightness if outflows continue.
Foreign Exchange Reserves and Trade Deficit
India’s foreign exchange reserves have also been affected. They fell by $17.8 billion, reaching a four-month low of $657.9 billion. Additionally, the merchandise trade deficit widened, hitting $27.14 billion in October. This indicates a growing gap between exports and imports, further straining the economy.
Factors Influencing System Liquidity
Several factors contribute to the current liquidity situation. A slowdown in deposit growth and fluctuations in monthly Goods and Services Tax (GST) payments have adversely impacted the overall liquidity in the banking system. Continued monitoring is essential to understand future trends.
Future Outlook
The ongoing challenges in the banking sector may persist if the balance of payments remains negative. Economists suggest that without important changes in foreign investment patterns and trade dynamics, the liquidity situation may continue to be precarious.
Questions for UPSC:
- Critically analyse the implications of a negative balance of payments on India’s economy.
- Estimate the impact of rising borrowing costs on small and medium enterprises in India.
- Point out the relationship between foreign portfolio investment and domestic liquidity in the banking system.
- What are the factors contributing to the widening trade deficit in India? Discuss with suitable examples.
Answer Hints:
1. Critically analyse the implications of a negative balance of payments on India’s economy.
- Negative balance of payments indicates more outflows than inflows, affecting currency stability.
- It can lead to depreciation of the rupee, increasing import costs and inflation.
- Reduced foreign exchange reserves may limit the RBI’s ability to manage monetary policy.
- Investor confidence may wane, leading to reduced foreign direct investment (FDI).
- Overall economic growth may slow down due to increased borrowing costs and reduced liquidity.
2. Estimate the impact of rising borrowing costs on small and medium enterprises in India.
- Higher borrowing costs increase operational expenses for SMEs, affecting profitability.
- It may limit access to credit, hindering expansion and innovation efforts.
- Increased costs can lead to higher prices for consumers, reducing demand for goods/services.
- SMEs may face challenges in meeting financial obligations, risking insolvency.
- Overall, rising costs can stifle the growth potential of SMEs, impacting job creation.
3. Point out the relationship between foreign portfolio investment and domestic liquidity in the banking system.
- FPI inflows increase domestic liquidity by providing additional funds to the banking system.
- Conversely, FPI outflows lead to liquidity tightening as capital leaves the market.
- High FPI activity can stabilize the currency, enhancing investor confidence and liquidity.
- Liquidity levels influence interest rates, which can affect FPI attractiveness.
- Overall, FPI acts as a barometer for market confidence and liquidity conditions in the economy.
4. What are the factors contributing to the widening trade deficit in India? Discuss with suitable examples.
- Increased imports of crude oil and gold contribute to the trade deficit.
- Slow growth in exports compared to rising imports exacerbates the deficit.
- Global supply chain disruptions can lead to higher import costs, widening the deficit.
- Weakness in key export sectors, like textiles and agriculture, limits foreign earnings.
- For example, the trade deficit rose to $27.14 billion in October, reflecting these pressures.
