Understanding
Liquidity
Liquid is something which is neither solid nor
gas. It is that which conforms to the shape of
the vessel containing it. Water is the best
example of a liquid. However in finance
liquidity has a very different meaning.
Liquidity in simple words means the
amount of money circulating and
available to all participants in the financial
markets.
Participants include individuals, corporate
entities and the government.
The most fundamental concept of economics;
Demand and Supply of money determine the
liquidity in the system.
And the central bank, the Reserve Bank of
India (RBI) has the power to increase or
decrease the liquidity in the financial markets
using various policy tools.
So in a sense we can imagine that the liquid tap
is housed within the RBI. If the level of liquidity
in the system drops, RBI has the power to
loosen the tap a little and allow more money to
gush into the system. Perhaps it is this
similarity that had led to the term liquidity
getting associated with money supply.
There are four main policy tools that RBI uses:
1) Cash reserve ratio
2) Open market operations/Liquidity
Adjustment Facility
3) 3. Repo and reverse repo rate
4) 4. Statutory Liquidity Ratio
So, what affects liquidity?
There are three ways that affects the liquidity in the system:
[Link] borrowings of the government to fund the deficit that arises
when its income falls short of expenses. Apparently, the
government is the biggest borrower in India.
[Link] by the corporate sector to fund capital expenditures
and short-term credit or working capital needs.
[Link]’s intervention in the Foreign exchange market to protect the
value of rupee from either excessive depreciation or appreciation.
What are the variables affected by
liquidity?
Commodities that are not available easily tend
to become costly. Money is no exception to
this. If the RBI prefers to reduce liquidity from
the financial system, the same is reflected by
increase in interest rates.
Put simply, the loans become costlier. At the
other end, borrowers will have to pay more to
raise money.
If there is ample liquidity in the financial system,
investors and speculators find it easy to raise
[Link] ensures that the asset prices rise.
Hence periods of low interest rates, with ample
liquidity in the financial system, create a good
environment for price rise across asset classes,
such as equities, commodities and real estate.
But if this continues unabated, it gives rise
to unfettered inflation which can cause
hardships for citizens across the social
strata. Very high inflation is debilitating and
hence RBI needs to step it to regulate
inflation by reducing liquidity.
But when liquidity is reduced, the
speculators find it difficult to hold on to their
positions due to non availability of money
and buyers. This causes asset prices to fall.
Therefore the RBI has to walk a tight rope to
ensure that neither inflation shoots up nor
conditions of very tight liquidity arise that
slows economic growth.
Thus the RBI Governor acts like a governor
that is often attached to a car to regulate its
speed. Such a car cannot speed up beyond a
prescribed limit. The governor along with a
good chauffeur would thus ensure that the
car neither goes too fast nor goes too slow.
That is how in a sense the speed of the
economy too has to be maintained.
Hope you have understood the concept of
liquidity.
Please give us your feedback at
professor@[Link]
Disclaimer
The views expressed in this lesson are for information purposes only and do not construe
to be any investment, legal or taxation advice. The lesson is a conceptual representation
and may not include several nuances that are associated and vital. The purpose of this
lesson is to clarify the basics of the concept so that readers at large can relate and thereby
take more interest in the product / concept. In a nutshell, Professor Simply Simple lessons
should be seen from the perspective of it being a primer on financial concepts. The
contents are topical in nature and held true at the time of creation of the lesson. This is not
indicative of future market trends, nor is Tata Asset Management Ltd. attempting to
predict the same. Reprinting any part of this material will be at your own risk. Tata Asset
Management Ltd. will not be liable for the consequences of such action.
Mutual Fund investments are subject to market risks, read all scheme related
documents carefully.
For more lessons visit
[Link]
