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We hear about it quite often. Perhaps it is the most widely used term in today’s financial world! We are talking about “liquidity” in markets. But what does this term “liquidity” mean? Simply put, it is the money that is present in a financial system and available to all participants including the individuals, corporate bodies and the government as well.

What determines liquidity?

The liquidity in a financial system is determined by the demand and supply of money. In India, this demand and supply scenario and subsequently the liquidity in the financial markets is regulated and managed by the Reserve Bank of India, the country’s central bank. This could be done in three ways.

The government of India is the biggest borrower in the country. Whenever there is a situation of deficit or shortage of income in meeting expenses, the RBI lends money to the government thus managing the liquidity.

Liquidity is also managed when the corporate sector borrows huge money in order to meet their capital expenditures and to fulfill the short-term credit needs of the sector.

On a few occasions when there is a need to maintain the value of the Indian rupee, the RBI would sell foreign units of currency and buy the Indian unit of currency and thus effectively reduce the availability of the Indian rupee.

What is the impact of liquidity?

When there is enough liquidity in the markets and low interest rates it gives a freehand for the investors to leverage thus pushing up the asset prices across classes like equities, commodities and real estate. However the central bank might act swiftly to suck out excess liquidity from the market when there are fears of a bubble formation in the assets market. This could impact the availability of certain variables in the economy making them dearer including money in the form of loans. Also, this step from the RBI could lead to hardening of interest rates.

Any reduction in liquidity and higher interest rates would mean that the investors and speculators would not be in a position to hold on to their assets due to non availability of money which could lead to fall in asset prices.

What should you do?

As an investor you should watch out for the announcements from the RBI regarding the interest rates and be prepared to act accordingly. That is when there is an increase in interest rates which could tighten the liquidity you should buy short-term bond funds as this will reduce the risk and give better returns.

Go for fixed maturity plans when you see that the corporate sector opting for large scale borrowings, to pay off the advanced tax payments, which could suck out money from the financial system and consequently pushing up the interest rates.

You could also find safe investments havens in instruments that have floating rates which could be good indicators of which way the interest rates are headed. Similarly if you are someone with high risk appetite they you could adopt leverage and big positions in assets of your choice.