The RBI may have to raise interest rates in the coming months. Before it gets to that decision, it has a more immediate problem to solve. Surplus liquidity has kept the overnight call rate below the 5.25% repo rate, weakening the first link through which monetary policy reaches the wider financial system.
The August meeting did little to settle the rate question. The Monetary Policy Committee left the repo rate unchanged and retained its neutral stance, but the minutes show growing concern about inflation. Deputy Governor Poonam Gupta pointed to the projected rise in headline inflation to 5.9% in the third quarter of 2026-27 and said a rate increase could become necessary. Governor Sanjay Malhotra also warned that a broader spread of food, fuel and input-cost pressures could require a policy response.
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That possibility has drawn attention to an awkward feature of current monetary conditions. The banking system has plenty of cash, and overnight interest rates have consequently tended to trade below the repo rate. If the RBI eventually raises rates, it will want that increase to pass through the money market rather than remain largely a change in the announced policy rate.
Why surplus liquidity matters
The weighted average call rate, or WACR, is the RBI’s operating target for monetary policy. Liquidity operations are intended to keep it close to the repo rate. That is the first stage through which a change in the policy rate reaches other money-market rates and, eventually, bank lending and deposit rates.
Large liquidity surpluses weaken this alignment. On August 6, for example, a four-day variable rate reverse repo auction helped lift the WACR to 5.18% from 5.05%, still below the 5.25% repo rate. The RBI has continued to conduct reverse repo operations to absorb cash from banks.
The problem has since become larger. Banking-system liquidity has averaged a surplus of more than ₹3.4 trillion in August, according to market data cited by Reuters. A major source has been foreign currency non-resident deposits raised by banks and swapped with the RBI under the special foreign-exchange facility introduced in June. Those swaps put rupees into the banking system.
The RBI’s own data showed net durable liquidity at about ₹5.36 trillion in mid-July. Market estimates now suggest that core liquidity could cross ₹9 trillion and approach ₹10 trillion as the remaining foreign-currency inflows enter the system and government cash balances change. These are forecasts rather than RBI projections, and seasonal currency demand could absorb part of the surplus.
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The limits of short-term liquidity operations
Variable rate reverse repo auctions are well suited to managing temporary liquidity. Banks place surplus funds with the RBI for a specified period, allowing the central bank to push overnight rates towards the policy rate.
Persistent liquidity requires a different calculation. The RBI’s operating framework distinguishes between frictional liquidity, generated by short-term changes such as tax payments or government expenditure, and enduring liquidity arising from longer-lasting changes in its balance sheet or banking-system reserves. Its toolkit for durable liquidity includes longer-tenor operations, open-market transactions, foreign-exchange swaps and changes in reserve requirements.
This distinction matters now. Repeated short-tenor auctions can absorb a large surplus for a few days, but the money returns when those operations mature. If the underlying surplus continues to grow, liquidity management becomes a rolling exercise.
That explains the market discussion around an incremental cash reserve ratio, or iCRR. The RBI has not announced such a measure. Economists and bond-market participants have suggested that it is one option the central bank could use if it decides that the liquidity surplus has become sufficiently durable.
The case for an incremental CRR
Banks are required to maintain a portion of their net demand and time liabilities with the RBI as cash reserves. An incremental CRR would require them to set aside an additional share of the increase in those liabilities.
The advantage is immediate. The RBI can immobilise a sizeable amount of liquidity without changing the repo rate. If excess reserves decline, overnight rates should move closer to the policy rate. Any subsequent increase in the repo rate would then have a better chance of tightening financial conditions.
There is a precedent. In August 2023, the RBI imposed a 10% incremental CRR on the increase in banks’ net demand and time liabilities between May 19 and July 28. The measure impounded about ₹1.1 trillion after liquidity surged partly because ₹2,000 banknotes were being returned to banks. The RBI treated the measure as temporary and phased it out by October 7.
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The circumstances today are different, but the logic is comparable. If the RBI concludes that a large part of the current surplus is durable, an iCRR can remove liquidity more directly than a succession of very short reverse repo auctions.
It also carries a cost. Cash reserves do not generate the return banks could earn by lending or investing the same funds. A large iCRR would therefore reduce deployable resources and could squeeze bank margins. Depending on its scale and duration, it could also slow credit growth. That argues for using the instrument selectively and withdrawing it once the liquidity distortion has eased.
Liquidity cannot replace the repo rate
The distinction between liquidity management and monetary policy should remain clear.
If inflation becomes broad-based and persistent, the repo rate is the appropriate instrument. It conveys the MPC’s judgment about the price of money across the economy. An iCRR does something narrower. It changes the quantity of funds available in the banking system and helps the operating rate reflect the policy rate more faithfully.
The August MPC minutes suggest that the possibility of a rate increase can no longer be dismissed. Meanwhile, the money market is telling the RBI that abundant liquidity could blunt such a move.
The sensible sequence is therefore to restore the link between the repo rate and overnight rates before asking a higher repo rate to do the work of restraining demand. If that requires absorbing part of the durable liquidity surplus, the RBI has several instruments available. An incremental CRR is one of them. It should remain what it was in 2023: a temporary tool for fixing the transmission mechanism, not a substitute for an interest-rate decision.