Why the liquidity crunch?

Liquidity in the banking system has dried up over the past few months. But what does one mean by ‘tight liquidity'?

It means that banks are borrowing for their daily requirements from the RBI. It is widely believed that the outflow of Rs 1 lakh crore from the banking system on account of 3G and BWA spectrum payments by corporates to the Government is the primary reason for the continuing liquidity deficit in the system.

But, the Government on its part had already spent a major part of this money by the first week of September. So the money has been ploughed back in to the system, and cannot be the only reason for continuing tightening of liquidity in the system.

According to us, the liquidity crunch is driven strongly by three major factors that are beyond the central bank's ability to address.

Negative real interest rates: The current high inflationary environment is resulting in a change in the consumption and savings pattern of the Indian population. . Thus, a large part of the income is concentrated now more on consumption (or you can say fulfilling current expenses) rather than saving.

This structural shift is expected to lead to a drop in the savings rate in the coming few years due to higher inflation.

Also, within his savings, his financial savings (ideally in the form of bank deposits) is fetching him negative real returns. This is the single most important reason for the current liquidity crunch.

Inflation continues to rule in double digits while the Bank FD rates remain closer to 7-8 per cent. This, in turn, leads to lower deposit mobilisation in the banking system.

Thus, the not-so attractive investment returns coupled with the higher cost of living is leading to the common man holding more cash.

Currency with Public: Between March and September 2009, there was an addition of Rs 56,708 crore in the currency with the public whereas for the same period this year, it doubled to Rs 1,01,905 crore. This surge in cash-in-hand for the common man has contributed to the liquidity deficit in the system. People are spending more as cost of living goes up sharply and more money is being put in hands of rural households. NREGA and higher Minimum Support Prices (MSPs) for crops are also ensuring that more money is pushed into the rural areas, which are under-banked, and more and more money is moving away from banks.

Rising Gold Demand: The other big reason for tight liquidity is soaring demand for gold and silver.

Indians, in first nine months of this year, have bought gold worth more than one lakh crore rupees and most of this purchase is funded by savings. According to figures in Gold Demand Trends' released by the World Gold Council (WGC), in value terms, India's gold demand grew to Rs. 113,302 crore from Rs.53,196 crore, an increase of 113 per cent. The total demand for gold is expected to touch 700-800 tonnes this year.

Much of this demand is coming on the back of the shift among consumers from financial savings to real savings. Thus, real assets such as gold, real estate, etc., are attracting investor allocation over bank FDs. Going forward, we expect deposit rates to move up by another 100 bps.

With credit growth rates remaining high, banks may raise the deposit rates further; so don't be surprised if your banker calls you up and offers you 9.5 per cent or even 10 per cent for a 1.5-2 year deposit by next quarter.

What does this all mean for a fixed income investor? Does the above explanation on tight liquidity provide for clues for forthcoming investment decisions? Debt products with characteristics similar to bank deposits may offer attractive returns. Fixed Maturity Plans are a good investment avenue for investors wanting take advantage of rising short-term interest rates. Also, investors should look at adding exposure to gold.

Source: http://www.thehindubusinessline.com/iw/2010/12/12/stories/2010121250270800.htm