Home / Opinion / Columns /  Does a liquidity crunch signal a business cycle upturn?

In April, the Indian banking system was flush with liquidity of more than 8 trillion. This is the money that swirls between banks and the reverse repo window of the Reserve Bank of India (RBI); i.e. overnight parking of excess funds. This money came easy, as was indicated by low overnight inter-bank borrowing rates that apply when banks with excess cash lend to their peers to meet temporary shortfalls. Even the repo rate, at which banks borrow overnight funds from RBI, was only 4%, which was less than the inflation rate, implying a real negative rate of borrowing. In just five months since then, that liquidity has vanished, and banks are facing a shortage. They are desperate for deposits, hence even the mighty State Bank of India (SBI) has raised deposit rates in the past one month. The SBI rate for a one-year foreign currency deposit (FCNR-B) is up by 90 basis points to 3.85%. Banks are now resorting to raising money through certificates of deposit (CDs), whose short-term rates are above 6.5%. Total mobilization of CDs by mid-September was nearly 2.5 trillion, whereas it was just zero a year ago.

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What explains this dramatic draining of liquidity and what does it portend? The first reason is that RBI had started indicating that it was changing its stance from being accommodative (i.e. a loose monetary policy) to “withdrawal of accommodation". Or, to put it simply, RBI turned its attention from supporting growth to controlling inflation. That is why its policy rate in five months has gone up by 190 basis points, and a further increase of 50 to 100 basis points is expected. The second reason is that RBI was also busy selling dollars and mopping up rupees in order to cushion the fall of the rupee. It is estimated to have sold $10-15 billion and that much worth of liquidity was taken out of the system. The total fall in RBI reserves has been more than $100 billion since last September, which is nearly 18%. This is the biggest drop among emerging market economies, and yet the rupee has fallen to 82 against the dollar. The RBI governor has said that 67% of the reserves’ fall was due to revaluation. But that still leaves 33%, most of which may have been sales by RBI to protect the currency. The third and very significant reason for a drastic fall in liquidity is that credit demand is far outstripping growth in demand deposits. Credit offtake growing at 16% is the highest in nine years, whereas deposit growth is just 9.5%. This gap between credit and deposit growth is also the highest it has been in 10 years. Growth in credit is usually a leading indicator of the status of a business cycle. Is it indicating an upswing? What is the supporting evidence?

Firstly, e-commerce companies showed robust growth of 28% in sales during the first few days of festive sale season online shopping. Secondly, growth in e-way bills, the digital trail of commerce, was about 35% during August. For intra-state movement of goods, the e-way bills generated showed a growth of 53% for some states like Maharashtra, Tamil Nadu, Gujarat, Karnataka and Uttar Pradesh. Thirdly, GST collections grew by 26% in September, 28% during August, and for six months in a row before that, intake had crossed 1.4 trillion per month. Based on advance taxes paid, the direct tax mop-up is up 30%. Perhaps that is why the finance secretary at the Centre recently said that he is confident of meeting or beating the fiscal deficit target this year. The government has also announced a slight dip in its revised borrowing requirement. Fourthly, imports have been rising, even of non-oil, non-gold items, indicating robust demand. Of course, it is causing a worry, given our widening trade deficit.

Automotive sales are growing, although more at the top-end, for four wheelers, while two wheelers and tractor sales growth is stagnant or declining.

It might thus be tempting to conclude that the liquidity crunch in the banking sector foretells an upswing in the business cycle. This conclusion needs to be tempered by other factors.

The fiscal situation might not be as comfortable as was described by the finance secretary. Note that the Union Cabinet has decided to extend the free food scheme, called the Pradhan Mantri Gareeb Kalyan Anna Yojana (PMGKAY), by another three months, despite protestations from the finance ministry. The additional cost for the PMGKAY is 44,000 crore. Thanks to high oil prices, the fertilizer subsidy this fiscal year will exceed 2 trillion, though only 1 trillion was budgeted. And then, a higher cost of borrowing, thanks to rising interest rates, means an additional burden of 20,000 crore to 30,000 crore.

The finance minister recently wondered why private sector investment was not forthcoming in a big way. That risk aversion or caution could be due to global recessionary concerns, and lack of conviction in durable demand that could justify capacity expansion in manufacturing. The central bank itself has revised its growth outlook downwards and so have many other agencies. The episode in the UK after its mini-budget, or any jolt in escalating geopolitical tensions, with “nuclear options" finding increasing mention at levels that should alarm us, could take the wind out of even the bravest and most diehard of optimists.

India is in a good spot in terms of its growth-inflation dynamics, but a high upswing in the country’s business or investment cycle is unlikely in the near term. Even if current signs of a liquidity crunch want you to think otherwise.

Ajit Ranade is a Pune-based economist.

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