It is ironic that when the global economy is worried about an impending liquidity withdrawal by the US Federal Reserve and there is a liquidity squeeze in China, banking-system liquidity in India improved to a nine-month high last week. The country?s banking-system liquidity deficit narrowed to less than R100 billion. To put it in context, liquidity in India has been tight for almost three years now. The Reserve Bank of India (RBI) defines a corridor of 1% plus or minus of net demand and time liabilities (NDTL) as its comfort level on daily balances under the liquidity adjustment facility (LAF), i.e. the amount of money banks borrow every day from RBI. This liquidity threshold is now about R760 billion but, interestingly, in only five of the past 18 months has the liquidity deficit been within RBI?s comfort level. What has been the reason for this persistent liquidity tightness?

We think that three different factors have been at play?structural, policy-induced and temporary. The lack of household financial savings is the structural cause behind low growth in bank deposits and, hence, liquidity tightness. The household savings rate has declined amid a slowing economy where income growth has been low, while households have tried to cling on to their old consumption baskets. High inflation has made matters worse. Income growth in rural areas has been stronger, but the effect of that on banking-system deposits may be weak because financial inclusion remains an unfinished agenda.

The decline in the share of household savings going into financial assets has been even more worrisome. The household financial savings-to-GDP ratio has dropped below 10% and reached a 20-year low. Tax-adjusted real returns on almost all financial assets (both debt and equity) have been negative over a five-year period, prompting households to look for alternative ways to invest. Incrementally, a larger share of household savings is getting invested in real estate and gold rather than in bank deposits. It is not surprising that house prices have stayed elevated even amid a slowing economy.

The decline in corporate profitability has been another reason for sluggish growth in bank deposits. Deposit growth has dropped to just 13-14%, versus over 20% less than two years ago. This decline in deposits has surpassed the reduction in credit growth, resulting in a liquidity squeeze. Although certain steps have been taken to disincentivise investment in gold and the issuance of inflation-indexed bonds, we believe that the challenge of structural liquidity will likely persist unless these measures bear fruit in the near term.

The second reason for the liquidity tightness is RBI?s monetary policy stance. Between 2009 and 2011, RBI kept liquidity tight because controlling inflation was the primary objective of monetary policy. Conventional wisdom is that monetary policy transmission works better when liquidity is tight. The operating rule of monetary policy was set to ensure that the overnight call money rate is as close as possible to the repo rate. This meant that banking-system liquidity had to be always kept in a deficit. However, from early 2012, growth concerns softened the monetary policy stance. The repo rate has since been cut by 125 bps, but the liquidity deficit has remained mostly above the comfort zone, despite RBI?s efforts to inject liquidity through open-market operations (OMOs) and cash reserve ratio (CRR) cuts. Unfortunately, RBI?s ability to infuse rupee liquidity was limited by the lack of a balance of payments surplus in FY12 and FY13.

Temporary liquidity tightness is often because of lumpy government revenue and expenditure patterns. We believe, however, that the recent improvement in liquidity is also because of certain temporary factors. The government spent more than usual in the past month, even through borrowing money from RBI in the ways and means advance (WMA) window (we estimate that the government?s cash position with RBI dropped to a deficit of R16 billion on May 24 from a surplus of R430 billion). This is a reversal from the trend in the past few months, when the government was running a substantial cash surplus, sucking out liquidity from the banking system. We believe that the current improvement in liquidity is also because of banks? likely under-maintenance of CRR balances last week following over-maintenance in the early part of the two weeks starting June 29.

We expect this improvement in liquidity to be short-lived and the liquidity deficit to likely increase to about R600 billion soon. However, the good news is that it is unlikely to breach RBI?s comfort level of close to R760 billion in H1-FY14. Nevertheless, the transmission of monetary policy is likely to be limited as long as there is a perception of liquidity tightness. RBI has cut the repo rate by 75 bps so far in 2013, but the top five banks have reduced their base rates by only 15 bps.

What should RBI?s response be in such a situation? If RBI eases liquidity further from current levels and the liquidity deficit moves to a surplus, short-term rates may fall by 100 bps. In the current binary framework, the overnight rate is either close to the repo rate (when liquidity is in a deficit) or close to the reverse repo rate (when liquidity is in a surplus). RBI cannot afford such a monetary easing when inflation risks are increasing on the back of a depreciating currency. Even the markets understand RBI?s concerns about inflation and will be surprised if, in this volatile global environment, RBI opts to ease liquidity further. In fact, we believe that, in the near term, RBI may be forced to pull back liquidity from the banking system if it chooses to intervene in the currency market to stem the pace of the rupee depreciation. H2-FY14 is likely to be a different story. We expect RBI to engage in additional OMOs of close to R1 trillion, but it may refrain from cutting the CRR any further. It will be relatively easier for RBI to keep the liquidity deficit within its comfort zone in FY14, but we believe that it is optimistic to assume that banking-system liquidity will switch to a surplus.

The author is managing director, regional head of research, South Asia, Standard Chartered Bank