14th December 2010

Frictional or Structural: The Liquidity Dilemma

The past several months have seen the money market face the tightest liquidity conditions it has seen – even surpassing the
tightness that occurred following the collapse of Lehman Brothers two years ago. Within the same financial year, we have seen
liquidity in surplus of ` 1 trillion to a deficit of close to ` 1.5 trillion. The tight liquidity conditions have led to a spike in interest rates
in the money markets offering the highest yields for over two years for investors.

Evolution of liquidity
While the banking system started the financial year with a large cash surplus, it turned into a deficit mode early in June after the
auction of 3G and BWA licenses. This also coincided with the Reserve Bank’s tightening monetary policy stance as it normalized
interest rates. The RBI announced in July its preference for maintaining tight liquidity to improve transmission of monetary policy
(rate hikes are more effective when liquidity conditions are tight).

Chart: Net Balances with RBI under Liquidity Adjustment Facility (` billion)
1500

1000

500

0
12-May-10
19-May-10
26-May-10

17-Nov-10
24-Nov-10
31-Mar-10

10-Nov-10
14-Apr-10

11-Aug-10
18-Aug-10
25-Aug-10

27-Oct-10
21-Apr-10
28-Apr-10

15-Sep-10
22-Sep-10
29-Sep-10

13-Oct-10
20-Oct-10
5-May-10

16-Jun-10
23-Jun-10
30-Jun-10

3-Nov-10
28-Jul-10
7-Apr-10

14-Jul-10
21-Jul-10

4-Aug-10

1-Sep-10
8-Sep-10

1-Dec-10
8-Dec-10
6-Oct-10
2-Jun-10
9-Jun-10

7-Jul-10

-500

-1000

-1500

(Source: Bloomberg)

Some key causes of the liquidity deficit have been:

 CRR hikes as part of monetary policy response to inflation
 Increase in currency in circulation (in part due to high inflation)
 Higher current account deficit
 High government cash surplus (which is parked with the RBI)
 Low deposit growth (deposit growth - 14.0% y-o-y - has been well below credit growth – 22.9% - this year)

Of these factors government cash surplus is relatively temporary (“frictional” in RBI terms), while the other factors are structural in
nature. In addition, this year has seen several large IPOs which have also contributed to short term liquidity imbalances in the
system.

The increase in currency in circulation in particular has acted as a severe drag on banking system deposits. In the normal process of
money creation a bank is able to create money (using the money multiplier effect) as long as the money remains in the form of a
deposit. If the deposits are withdrawn, it creates a similar effect to a CRR hike. The current financial year has seen the highest
growth in currency in circulation (i.e. currency outside the banking system) in the past 10 years, both in terms of absolute amounts
and in the percentage change.
 14th December 2010

Table: Growth in currency in circulation (Fiscal Year To Date)

Year Amount (` bn) % increase during FY
FY01 168 8.88%
FY02 257 12.26%
FY03 238 9.89%
FY04 277 10.22%
FY05 333 10.57%
FY06 365 10.27%
FY07 409 9.91%
FY08 470 9.73%
FY09 536 9.43%
FY10 495 7.44%
FY11 1039 13.52%
(Source: RBI)

The increase in currency demand could be due to a multitude of factors including higher inflation, government spending in rural
areas and pick up in cash-rich activities such as real-estate.

The current liquidity scenario is well outside the RBI’s stated comfort zone of net liquidity balances within 1% of net demand and
time liabilities of the banking system. The chart below illustrates the movement in liquidity in a historic context. The current level of
tightness is similar in magnitude as seen during the peak of the global financial crisis following the bankruptcy of Lehman Brothers.
However, the key difference is that the current systemic liquidity deficit is a result of monetary policy rather than an exogenous
event.

Chart: Net LAF Balances as % of Aggregate Deposits

5.0%

4.0%

3.0%

2.0%

1.0%

0.0%
Mar-04

Jun-04

Mar-05

Jun-05

Mar-06

Jun-06

Dec-06

Mar-07

Jun-07

Mar-09

Mar-10
Dec-03

Sep-04

Dec-04

Sep-05

Dec-05

Sep-06

Sep-07

Dec-07

Mar-08

Jun-08

Sep-08

Dec-08

Jun-09

Sep-09

Dec-09

Jun-10

Sep-10

-1.0%

-2.0% Lehman Brothers’

bankruptcy

-3.0%

(Source: Bloomberg)
 14th December 2010

Impact of liquidity conditions on money market yields

Banks, which had been reluctant to increase deposit rates in an easy liquidity environment, were forced to respond by increasing
deposit rates. Over the past six months, three-month interest rates on certificates of deposit have risen by nearly 300 basis points
and since the start of the financial year, rates have risen by 400 basis points in response to repo rate hikes and the tight liquidity
conditions.

Chart: Movement in 3-month and 12-month CD Yields

10

8
Yield (%)

4
Apr-10

Jun-10

Oct-10

Nov-10
Mar-10

May-10

Jul-10

Aug-10

Sep-10

Dec-10

3-M CD Yield 12-M CD Yield

(Source: Bloomberg)

Outlook for policy

The present conditions are challenging for the Reserve Bank. On the one hand, tight liquidity is consistent with its inflation fighting
stance. On the other the negative balances in the LAF are far in excess of the RBI's own comfort zone – and if allowed to persist –
could lead to negative impact on credit growth and economic growth in the future.

The RBI has taken certain steps to alleviate the impact on the banking system. It has temporarily reduced the Statutory Liquidity
Ratio (SLR) by 2% till January 28. In addition the RBI & the government have been conducting Open Market Operations to purchase
government bonds. We expect the RBI to continue with further OMOs in the near term. One key step that the RBI could take to
improve liquidity is a cut in the Cash Reserve Ratio (CRR). However, the RBI is concerned that this may be viewed as a rate cut signal,
and is therefore contrary to its monetary policy stance.
 14th December 2010

Opportunity for investments

The spike in rates due to the tight liquidity environment gives investors in the debt markets opportunities to invest in high-yielding
short term debt instruments. As yields have increased in the money market, it is possible to invest in shorter tenor instruments
without taking on the interest rate risk associated with longer tenor securities. Funds with low duration (liquid funds, short term
funds and fixed maturity plans) offer relatively stable returns and are likely to outperform.

Currently all the Axis Mutual Fund fixed income schemes follow a low duration stance focussing on accural of income over taking
duration / interest rate risk.

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Source of data: Bloomberg, RBI