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Sahil Kapoor
Sep 20, 2021 7 mins
Find out what liquidity means and why everyone talks about it. This blog breaks down the concept and its importance in investing. This blog provides in-depth analysis and practical advice. These funds are suitable for long-term investors looking to save on taxes. They offer a unique combination of tax savings and potential for high returns over time.
“Stocks are going up because there is so much liquidity.”
“Valuations are high and will remain high because there is a flood of liquidity.”
Liquidity is blamed for any and everything, usually. Bulls love it, bears blame it. But one thing is common. When you ask investors – “What is liquidity?” - what you get in return are empty stares, smiles, or at best, fund flows or traded volumes data.
Have you ever asked this question to yourself? What is liquidity and how to define it?
In a corridor conversation early in my career, I was often told that the flood of money brought forth by quantitative easing is going to lift the markets like never before. On other occasions, derivative traders mentioned the open interest rising with rising volumes and termed it ‘long buildup’ in a stocks. It was an indication that the ‘strong hands’ in the market liked this scrip.
One of the most familiar references to liquidity is usually the FII and DII flows. It is a common practice to state these as the primary, and for most investors, the only tool to measure ‘liquidity’ in the stock market.
This confused and perplexed me so much that I wrote a simple cheat sheet to tell myself what liquidity is. Here it is –
Liquidity, the most potent and important source of market moves, is of three primary types –
1. Market Liquidity
2. Interbank Liquidity
3. Credit availability and off-take
Let’s look at each one of these in brief.
The large inflow of foreign institutional investors (FIIs), who bring in foreign portfolio investments (FPIs), have been regarded as one of the key determinants of market behaviour. India’s listed company total market capitalization is now nearly Rs 250 tn. Nearly half of this is held by promoters and the rest is ‘free-float’. FPIs hold nearly one-third of the free-float market capitalization. Their holdings are mostly consolidated in larger companies, and therefore, FPIs’ buying and selling of shares can have an outsized impact on stock prices.
Over the years, domestic institutions including mutual funds have seen their share of holding of stocks rise from nearly 10% to about 15% of the free-float now. Even small changes in shareholding from these institutions can cause large movements in stock prices, and are, therefore, a key monitorable for many traders and investors.
Daily FII and DII put together account for half the daily traded volumes on the cash market each day. Domestic mutual funds have become significantly large in terms of their total holding of Indian stocks. The consistent flows through SIPs and evolving trend in equity ‘Asset Under Management’ can help one to prepare for changes in the buying and selling pattern during volatile market phases.
Often, FPIs and DIIs behave differently by buying and selling alternatively. This creates powerful trends in the stock markets. It’s important to keep track these trends and gauge why they change.
The other part of market liquidity refers to the abundance of market orders and the depth at which the market is operating. This is usually a function of market sentiment and trending behaviour.
Long and stable uptrends attract lot of investors, and they keep bidding up the prices. It is said that bull markets feed off from consistent flows from the retail investors -knowing fully well that this is a virtuous feedback loop which evolves as the markets rise and it turns on itself when they correct. It is a sort of Frankenstein which bull markets develop, and it turns on itself when the trend changes.
Most investors face very poor market prices, wide bid-ask spreads and shallow volumes when prices fall precipitously. One rule of thumb which helps in avoiding mishaps has been that no major world equity index has ever hit a lower circuit while trading above its 50-day moving average.
In similar view, rising open interest with rising volumes allows stocks in futures and options segments to have faster moves as leverage positions favour these counters - knowing fully well, from one expiry series to the next, the kind of open interest changes happening helps in identifying the leader of a market.
The flavour of the above few can be set in an excel sheet with just a few rows and columns. When tracked daily, it helps in knowing how liquid is the market.
The second and most often quoted is the interbank liquidity. This became famous and continues to remain the top favourite of participants and media since the global financial crisis.
As of June 2021, the banking system had liabilities of Rs 164 tn (client demand and time deposits) and approximately Rs 16 tn in capital. This funds Rs 110 tn in loans and Rs 54 tn in reserve assets.
CRR and SLR constitutes the reserve assets. As per RBI’s guidelines, banks must maintain 4% of CRR and 18% of SLR of Net Demand and Time Liabilities (NDTL). So at about Rs 164 tn of NDTL, banks should maintain Rs 6.5 tn in CRR and Rs 29.5 tnin SLR (through HQLA).
On any given day, if the banking system holds surplus CRR balance over and above Rs 6.5 tn, this is a surplus and is given the name interbank liquidity surplus. Also if the banking system holds high quality liquid assets in SLR over and above the statutory amount, it adds to banking system liquidity. For instance, at this time, the banking system holds nearly Rs 16 tn in excess HQLA (High Quality Liquid Assets) over and above the statutory requirement of Rs 29.5 tn .
Of course, the above is a simplistic example of looking at interbank liquidity surplus. There are ways in which this liquidity changes everyday at the liquidity adjustment facility (LAF) window of the RBI. Here, banks can covert one form of surplus to the other to cover its deficit elsewhere, say from SLR to CRR. So, in effect, it maintains a total statutory level of CRR + SLR.
This is the interbank liquidity surplus which is talked about often as the key liquidity measure. RBI has maintained an interbank liquidity surplus for nearly five years now and this has resulted in easier financial conditions. However, this interbank liquidity can’t be lent out in the literal sense. When there is fresh demand for loans, and banks makes a loan, it creates another deposit in the borrower’s account. Thus, lending creates new money and this is the largest money multiplier.
What surplus interbank liquidity does is it keeps financial conditions easy, rates lower and outlook more visible for the near future. This allows banks to meet demand for credit, if it picks up with better visibility.
Let’s first look at the money supply. There are three key variables to understand
M1 - zero-yielding currency notes, coins and bank demand deposits
M2 – M1 and all the post office savings bank deposits
M3 – the broadest measures which includes M1 and all the times deposits with the banking system.
Central banks usually have policy tools such as changing short term interest rates like the repo rate, or changing the liquidity profile of the banking system by cutting the statutory ratios like the CRR and SLR. When a central bank wants to enact a counter cyclical policy to promote growth or fight deflation, it employs a number of measures. It cuts short term interest rates, increases liquidity surpluses in the system and supports the interbank market.
It can also achieve lower rates by raising the amount of money in circulation. Usually, central banks target M1 by raising currency in circulation, that is printing of more currency notes. However, the real impact on the economy is when the broader money (M3) moves higher. The biggest driver of broader money (to put it simply, about two-thirds or more) is contributed by changes in demand for loans which are a function of term deposits and demand deposits. It is a sort of chicken and egg.
When a bank lends, it creates a deposit in the borrower’s bank. The subsequent transactions create the flow of money and has a multiplier impact. More loans create more deposits which allows banks to lend more. In short, lending creates its own deposits.
The underlying fact is that the central banks can do little to create demand for loans. All it can do is create conducive conditions for borrowers to borrow. In short, Central Banks have little impact on M3 if it only uses its conventional monetary policy tools.
A growth in broad money supply is a reliable indicator of economic growth. The central banks, unable to move M3 much through conventional policy then rely on what is called the unconventional monetary policy or Quantitative Easing (QE). The central banks, through the secondary market, buys Government Securities and other high quality assets from financial participants, which are mostly banks. This causes the yields on those papers to fall as the central banks become the buyer of the last resort, and in some cases, the largest buyers in the market. The fall in yields and concomitant rise in bond prices causes balance sheets to improve and adds more heft to the conventional policy tools.
What it also does is create a search for yields. Because fixed income assets, or bonds, start giving lower returns. investors are likely to shift their allocation in favour of riskier asset classes like equities. This causes the balance sheet of the corporate sector to improve tremendously as their equity prices rise and they raise money cheaply. This creates a virtuous cycle which eventually revs up the economy through higher corporate and government spending. This is the most ideal cycle that central banks target but may need many more other factors to go right.
In essence, the quantitative easing cycle is a support function of conventional monetary policy. It works wonderfully in economic setups which have strong underlying potential growth.
Let’s see where we stand today:
The pandemic has taken India out of monetary repressions where most liquidity numbers have normalized. The flair of excess liquidity is visible only in the market liquidity. Structural liquidity has only filled the gaps but can’t be termed as “excess” thus far. After all, “excess” is relative!
The liquidity matrix at this time is flashing red at many places. The outstanding contracts in the futures and options markets is one such place. The extreme readings on interbank liquidity also mean that a reversal even to the surplus standards of the past can cause large volatile episodes in stocks. Be wary of deep gashes when the above mean revert.
Liquidity has many flavours and shapes. We need to track all of them to arrive at an understanding of what constitutes liquidity. So next time when some ones says that stocks are rising because of liquidity, know that there can be many ephemeral or structural factors at play.
At this time liquidity is surplus in most of its forms and is keeping most asset classes buoyant. But there are kinks in the armour because we are in a no man’s land and we do not know the path of return. Be prepared for big moves ahead as liquidity changes shapes and colours.
Sahil Kapoor is Vice President & Head - Products & Market Strategist at DSP Asset Managers. In his own words, his writing is his "Gurudakshina" - his humble repayment to Mr. Market
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