The queue at the bank’s counter never seemed to budge. Anbarasu was on his phone scrolling through a news app. One of the headlines caught his attention: RBI to hold OMO auctions worth ₹1 lakh crore to boost liquidity. Puzzled, he turned to his pal Nallasivam.
Anbarasu: Nalla, what is this OMO? What has it got to do with liquidity?
Nallasivam: To understand that you’ll need to get the basics straight.
Anbarasu: Go on. I’m all ears.
Nallasivam: First thing, let me explain what liquidity. Banking system liquidity refers to whether banks have sufficient cash to handle withdrawals, loans and other financial commitments. Now that liquidity is low in the system, RBI has resorted to OMOs to boost liquidity.
Anbarasu: Okay… but, how did we reach here in the first place? I mean, the low liquidity situation.
Nallasivam: Good question. There is more than one reason. I’ll point out a few.
Till April of 2024, we had a similar liquidity deficit. The situation eased from then and for six months, there was adequate liquidity. Then again in November 2024, liquidity issues surfaced. FPIs were repatriating big time by selling their holdings in India. That led to demand for the dollar and the rupee slid. To protect the rupee, the Reserve Bank sold dollars, about $70 billion, to nullify the demand to some extent. The RBI would have done this by buying rupee from the system, in exchange for those dollars. This is one of the reasons of how rupee exited the system, and created a liquidity crunch.
Another reason is that taxpayers have advance tax liability in December. As they discharge advance tax obligations, money moves out of the system into the government’s coffers. This is a short-term phenomenon though. As government spends that money, like paying a road builder for instance, money will be back in the system. As 2024 was a slow year for government expenditure, the problem was amplified. This apart, slow growth in bank deposits too, added fuel to the fire.
Anbarasu: Now I clearly get it. Okay, now tell me what OMO is.
Nallasivam: You see, OMO or open market operations are one of the tools at RBI’s disposal to control the money supply in the economy. When liquidity is down in the system, it buys government securities from banks for cash. The RBI orchestrates this through an auction.
Anbarasu: So, it’s a bit like why I’ve come here. If I surrender my fixed deposit certificate, the bank will give me cash to spend. Likewise, right?
Nallasivam: Roughly, yes.
Anbarasu: And let me guess, if there is too much liquidity, RBI will pull out excess cash from banks by selling them G-secs.
Nallasivam: Attaboy! You know what’s in it for you and me as investors?
Anbarasu: Enlighten me.
Nallasivam: First, this is good for bank stocks. As there is enough liquidity, banks can advance more loans, the core revenue generating asset for them.
On the other hand, this is bad news for short-term investors in the money market, such as investors in overnight funds and liquid funds. As the liquidity crunch eases with a higher money supply, short-term yields drop, since the need for borrowers to pay more interest is negated.
“Next up Anbarasu”, cried out the clerk, as Anbarasu looked on at Nallasivam with gratitude.
