How central banks shape liquidity production: The case of India

Jain, Sudeep

Abstract

This thesis develops a theoretical framework to study the role of central banks in shaping liquidity production in different financial structures and applies the framework to India. The theoretical framework draws on the three different ways in which scholars have interpreted the concept of liquidity—monetary liquidity (bank reserves held with the central bank), funding liquidity (ease of accessing cash) and market liquidity (ease of buying or selling a financial asset). The framework consists of two pillars. The first one represents how central banks create monetary liquidity, and is shaped by the monetary-fiscal nexus, capital account policy and exchange rate policy. The second pillar represents the link between funding liquidity of financial institutions and market liquidity of collateral in the money market. To examine how this relationship operates in different financial structures, the thesis develops the concept of position-making structures, which build on Minsky’s concept of position-making. A position-making structure undergirds the money market, and is of one of two types, depending on whether the purpose of the money market is to meet cash demands primarily arising from bank deposits issued in the process of making loans (deposits-focussed position-making) or to enable the financing of securities by issuing repo liabilities (repo-focussed position-making). The ability to leverage collateral, which ties funding liquidity of financial institutions to market liquidity of collateral, is essential to repo-focussed position-making. The position-making structures, in turn, map on to the two financial structures, bank-based finance and market-based finance.

The empirical section chronicles the evolution of India’s monetary liquidity framework and position-making structure following the economic reforms of the early 1990s, narrating how the RBI has resisted market-based finance while adopting a Neoliberal monetary liquidity framework. It shows how a system of shadow repo-focussed position-making developed in the early 1990s, culminating in a scam that prompted the Indian central bank to restrict leveraged trading of collateral and to double down on bank-based finance. At the same time, India was moving towards a monetary liquidity framework dominated by capital flows.

Following the Great Financial Crisis, the central bank continued to resist liberalizing repo markets, leading to the rise of non-bank-lending without market-based finance. The thesis concludes with policy implications for DECs and an agenda for further research.

• Thesis Type: Thesis
• Deposit Date: Oct 3, 2022
• Publicly Available Date: Jun 21, 2023
• Public URL: https://uwe-repository.worktribe.com/output/10017916
• Award Date: Jun 21, 2023