What is Liquidity?
Liquidity simply means the amount of money floating in the system that is available to all participants in the financial markets, which includes individuals, corporate entities and the government.
What affects liquidity?
Liquidity is influenced by demand and supply of money in the system. The Central bank, the Reserve Bank of India, can increase or decrease the liquidity in the financial markets. There are three ways the liquidity gets affected. First, the borrowings of the government — the biggest borrower in India — to fund the deficit that arises when its income falls short of expenses. Second will be the increased borrowings by the corporate sector to fund capital expenditures and short-term credit needs. A third reason could be a reduction of availability of the rupee by the central bank by buying rupee and selling a foreign currency such as the US dollar. This is primarily done to maintain the value of rupee. The central bank prefers to withdraw excess liquidity from the financial market when asset prices near a bubble situation.
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 central bank prefers to reduce liquidity from the financial system, the same is reflected by a hardening of interest rates. It is especially visible at the short end of the yield curve. 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 leverage. This 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 the liquidity is reduced, the speculators find it difficult to hold on to their positions due to higher interest burden or non availability of money. This results in a fall in asset prices.
What should investors do?
As the central bank makes their stand clear on policy issues such as interest rates, investors should be prepared to take advantage of the same.
When the interest rates enjoy upward bias and liquidity is seen tight, it makes sense to go for short-term bond funds to enjoy good risk adjusted returns. As liquidity tightens, the short end of the yield curve finds the maximum movement and short-term bond fund managers, if they can catch the movement, reward investors well.
There are events where large-scale borrowings from the corporate sector draws money out of the system, pushing interest rates up. This is the time one can lock in returns by investing in fixed maturity plans. Traditionally, such opportunities were seen ahead of advanced tax payments by the corporate sector, when the liquidity in the system goes down.
Investors can also find solace by investing in floating rate instruments, to catch interest rate movements arising out of a modification in liquidity in the financial system. Investors with high risk appetite can consider resorting to leverage to build big positions in assets of their choice.
