Huge liquidity surplus unlikely to be inflationary, say economists

The banking system continues to remain flush with liquidity, and the Reserve Bank of India (RBI) is in a no hurry to neutralise it.

High system liquidity is generally a cause for concern as it can stoke inflation, but the situation now is quite different. Instead of pushing up inflation, the huge surplus liquidity, bordering at around ~7 trillion daily, is helping in policy rate transmission and aiding the government to borrow at a cheaper rate.

Therefore, analysts expect this liquidity surplus mode to continue well into the next year, till such time the economy starts picking up and capacity utilisation increases to a reasonable degree of say nearly 80 per cent, from below 70 per cent now. Of course, the borrowing programme for this year has to end before any thought on liquidity should cross the mind of the regulator, say experts.

“The liquidity surplus helps support government borrowing. It is actually substituting revenue shortfall, and would not lead to inflationary forces now as spending is low and there is low capacity utilisation, which can be ramped up if needed,” said Madan Sabnavis, chief economist of CARE Ratings.

The annual government borrowing is pegged at ~12 trillion, without yet counting a possible extra borrowing towards the end. Half of this has already been done at around the 6 per cent-mark, thanks to the surplus liquidity in the system. This is also serving an important function for the central bank — keeping the interest rates low.

Abundant liquidity is unlikely to be inflationary when the economy is operating well below potential and aggregate demand is so weak, according to Gaurav Kapur, chief economist of Indusind Bank.

Instead, the large surplus liquidity is definitely helping in keeping cost of borrowings, up to three years, low for various class of borrowers and had reduced the refinancing risk significantly. “In essence, a financial logjam has been averted through lower rates and liquidity support,” Kapur said.

“The role of monetary policy to stimulate the economy is to reduce the interest costs across various class of borrowers and through various channels — banks and bond markets. Transmission of monetary signals to the long end of the yield curve along with lending rates is going to be a priority going forward,” said Kapur.

In a contracting economy, the usual assumptions may not always hold true. “The long-standing assumption of downward nominal wage rigidity in 1969-1970s, and hence the wage price nexus stemming from inflation expectation, is absent right now with weakening organised labour market activity,” said Soumya Kanti Ghosh, group chief economic advisor of State Bank of India group.

“With people holding cash, there is a collapse of money multiplier. Under such circumstances, liquidity is unlikely to drive inflation at least till the time demand picks up,” Ghosh said.