Liquidity surplus: India’s banking system has acquired a problem few lenders would ordinarily complain about: more money than it can readily deploy. Policy measures designed to attract foreign currency brought in $136.4 billion by August 31, including $127.2 billion through Foreign Currency Non-Resident (Bank) deposits. The response prompted the Reserve Bank of India to close the deposit scheme on August 31, a month ahead of schedule, though banks could use its swap window until September 11.
Under the special facility, banks raised fresh FCNR(B) deposits and swapped the foreign currency with the RBI for rupees at no hedging cost. The deposits have maturities of three to five years. The RBI gained foreign-exchange resources, while banks received rupee funding that can support domestic lending.
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The inflows have also produced an exceptional liquidity surplus. It reached ₹9.7 trillion in early September, according to bankers cited by Reuters. Subsequent estimates placed core surplus liquidity at ₹14–15 trillion. The question is whether banks can put this money to productive use without compromising loan appraisal or inflating asset prices.
Liquidity surplus does not automatically create a bubble
The inflows strengthen bank funding and reduce dependence on expensive wholesale deposits. They also give the RBI greater room to manage the rupee and its foreign-exchange position. Moody’s has said the FCNR(B) deposits should improve the funding and liquidity profiles of Indian banks.
Yet liquidity is useful only when matched by creditworthy demand. If funding grows faster than viable lending opportunities, banks may compete for the same borrowers. Lending rates fall, covenants weaken and projections that would once have invited scrutiny begin to pass credit committees.
That process can support an asset bubble, though the present data do not establish that one has formed. A bubble requires more than rapid credit growth. Borrowing must begin to feed asset-price increases, which then provide the collateral for further borrowing. Expectations of rising prices eventually replace underlying cash flows as the basis for lending.
Some credit segments merit attention. India’s non-food bank credit grew 19.1% from a year earlier in July. NBFC loan books expanded 14.9%, with retail credit up 21.4% and commercial real-estate loans rising 22.3%. Gold loans grew 68.5%, helped in part by higher gold prices. These rates may reflect legitimate demand and a favourable base, but they also identify the areas where underwriting standards should be watched.
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Where the money goes
Banks can use surplus funds to buy government securities, replace costlier deposits or extend loans. An individual bank can also place money with the RBI. The implications differ sharply.
Demand for government securities can lower yields and produce capital gains for bondholders. Replacing expensive funding improves margins without adding much new credit to the economy. Fresh lending has a wider effect because borrowers use the money for consumption, investment or asset purchases.
There is, however, an important distinction between liquidity held by one bank and liquidity in the banking system as a whole. A bank can lend its surplus to another bank or purchase securities from another market participant, but the rupees remain within the system. Only the RBI or the government can drain the aggregate surplus. Banks can redistribute liquidity; they cannot collectively eliminate it.
This places the burden of adjustment on the central bank. The RBI has used variable-rate reverse repo auctions, but a 30-day operation in early September received a weak response. It subsequently entered the foreign-exchange market through sell-buy swaps, absorbing rupees in exchange for dollars and agreeing to reverse the transaction later. Market participants estimated that the RBI conducted about $1 billion of such swaps on September 9 and another $600–700 million the following day.
These transactions provide temporary relief. They also allow the RBI to manage its forward foreign-exchange book. But they postpone rather than settle the larger question of how much structural liquidity the banking system can absorb.
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Real estate and leveraged assets need scrutiny
The immediate risk lies in sectors where credit availability and collateral values reinforce each other. Easier finance allows a developer to bid more for land. The higher transaction price then raises the apparent value of nearby property and strengthens the collateral offered for another loan.
Similar feedback can develop in equities, infrastructure assets and private credit. Loans against gold require particular care because the value of the security has risen rapidly. A higher gold price increases borrowing capacity even when the borrower’s income has not changed. A reversal in the price can expose lenders that relied too heavily on collateral coverage.
Commercial real estate presents a different problem. A 22.3% increase in NBFC credit to the sector need not signal distress, especially if it finances completed projects with stable rental income. Loans based on ambitious occupancy assumptions or rising land values deserve closer examination.
The appropriate response is not a broad credit clampdown. India still needs bank finance for productive investment, housing and smaller enterprises. Crude restrictions would penalise sound borrowers and weaken monetary transmission. Supervision should instead concentrate on loan-to-value ratios, unsecured retail portfolios, connected exposures and the assumptions used to value collateral.
The FCNR(B) inflows have given banks valuable medium-term funding and strengthened the RBI’s foreign-exchange position. They have also transferred part of the adjustment problem to domestic money markets. If the central bank drains too little liquidity, underwriting may weaken. If it drains too aggressively, money-market rates could rise and frustrate the purpose of the facility.
For now, the liquidity glut is a warning rather than evidence of a bubble. The decisive indicators will be where incremental credit goes, whether loan terms deteriorate and whether asset prices begin to determine credit decisions. The RBI must ensure that a successful effort to secure foreign currency does not leave the banking system with more risk than it can price.