Surplus Liquidity in the Banking System [UPSC Notes]

What is meant by surplus liquidity in the banking system? How does it affect the economy? This is an important topic that IAS aspirants must be aware of and understand in order to write well-rounded answers to questions based on economics. This can also help in the UPSC prelims exam.

Surplus Liquidity

Surplus liquidity refers to the excess funds or cash available in the banking system beyond the immediate requirements of banks and the economy.

• It is indicated by the monetary value absorbed by the Reserve Bank of India (RBI) from the banking system.
• Surplus liquidity can arise due to various factors such as deposit inflows, government spending, the redemption of government bonds, and currency leakage in the rural sector.
• Surplus liquidity provides additional funds to the banking system, which can have an impact on interest rates, money supply, and overall economic conditions.

Factors Affecting Surplus Liquidity

• Withdrawal of Rs 2,000 notes: The recent deposit of Rs 2,000 notes, which were withdrawn from circulation, has contributed to the increase in surplus liquidity.
• Redemption of government bonds: The redemption of government bonds has added to the surplus liquidity in the banking system.
• Higher month-end spending by the government: Increased government spending at the end of the month has also contributed to surplus liquidity.

Impact and Implications of Surplus Liquidity

• Interest rates: Surplus liquidity can put downward pressure on interest rates as banks have excess funds to lend.
• Money supply: The increase in surplus liquidity expands the money supply in the economy, which can have implications for inflation and overall economic growth.
• Exchange rate: The sale of dollars by the RBI to defend the rupee can reduce rupee liquidity in the banking system, impacting the exchange rate.
• RBI’s actions: The RBI monitors surplus liquidity and takes appropriate measures to maintain stability in the banking system. It conducts reverse repo auctions to absorb excess liquidity or inject liquidity through repo auctions if needed.

Expected Decline in Surplus Liquidity

• Advance tax and GST payments: The upcoming payments of advance tax and GST are expected to reduce surplus liquidity as businesses and individuals make their tax payments.
• Currency demand in rural areas: During the crop sowing season, there is typically higher currency demand in rural areas, which can lead to a decrease in surplus liquidity.
• Analysts’ expectations: Economists and analysts predict that the surplus liquidity in the banking system will decline to around Rs 1.3-1.5 lakh crore by June ’23 end.

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