RBI’s ₹3 trillion liquidity infusion: The Reserve Bank of India is grappling with a liquidity shortfall that no longer resembles a routine year-end squeeze. In response, it has announced a ₹3 trillion infusion through open market purchases of government securities and a long-tenor dollar–rupee swap. These measures are meant to offset liquidity drained by foreign exchange intervention and seasonal cash outflows. But the scale, persistence, and frequency of these actions suggest something more structural: India’s liquidity management framework is under sustained stress.
This is not merely a technical challenge for the RBI’s operations desk. It reflects deeper changes in capital flows, government cash management, financial market structure, and the limits of a monetary policy framework designed for a more stable world.
READ | RBI interest rate cuts risk fuelling asset bubbles
Why liquidity infusion matters more than rate cuts
Liquidity is the plumbing of the financial system. Adequate reserves keep overnight rates anchored to the policy corridor, allow banks to lend without balance-sheet anxiety, and ensure that policy signals pass through to borrowers. When liquidity tightens, this chain breaks. Money market rates harden, banks conserve cash, and loan pricing becomes insensitive to repo rate cuts.
India has seen this repeatedly over the past year. Despite policy easing, monetary transmission weakened as system liquidity slipped into deficit. As Policy Circle noted earlier, the contraction in the monetary base coincided with one of the sharpest liquidity squeezes in over a decade, blunting the impact of rate reductions. In such conditions, the policy rate loses traction unless liquidity is restored.
The RBI’s latest liquidity response
The central bank’s latest measures are a direct response to this squeeze. In December, banking system liquidity turned negative after months of surplus. The immediate triggers were familiar: dollar sales to smooth rupee volatility, advance tax payments that temporarily park funds with the government, and higher demand for currency in circulation.
To counter this, the RBI announced four tranches of government bond purchases worth ₹2 trillion and a three-year $10 billion USD/INR buy-sell swap. OMOs inject durable rupee liquidity, while long-tenor swaps replenish liquidity drained by forex intervention without permanently expanding the central bank’s balance sheet. Together, they are designed to stabilise overnight rates and prevent a credit slowdown.
READ | RBI must let the rupee settle closer to its real value
The forex–liquidity trade-off
At the heart of the problem lies the RBI’s foreign exchange operations. When the central bank sells dollars to curb excessive rupee volatility, it withdraws rupees from the banking system. This trade-off has always existed. What has changed is how often it is triggered.
Capital flows have become more erratic, foreign portfolio inflows remain uneven, and global financial conditions—driven largely by US monetary policy and trade uncertainty—continue to buffet emerging market currencies. The rupee’s movements this year reflect these external pressures more than domestic imbalances. Each bout of intervention tightens liquidity, forcing the RBI to step in again with compensatory operations.
What remains unclear to markets is the medium-term strategy. Is the RBI willing to tolerate greater exchange rate flexibility to preserve domestic liquidity? Or will it continue to defend the rupee while relying on repeated liquidity injections to offset the impact? The absence of an explicit sterilisation framework adds to uncertainty.
Fiscal cash management and the hidden liquidity drain
Liquidity stress is not driven by monetary factors alone. Government cash management has emerged as a significant, and often underappreciated, source of volatility. Large and fluctuating cash balances held by the Centre with the RBI act as an inadvertent liquidity sink. When spending lags borrowing, funds are effectively withdrawn from the banking system.
The heavy use of Treasury Bills for short-term financing further tightens money markets, even as the RBI injects durable liquidity through OMOs. The timing mismatch between government receipts and expenditure amplifies swings in system liquidity—over which the central bank has limited control. This turns liquidity management into a coordination problem between fiscal operations and monetary policy.
READ | Will RBI’s repo rate cuts bring relief to homebuyers?
Why markets remain unconvinced
Despite the RBI’s actions and a 25-basis-point repo rate cut in December, bond markets remain uneasy. The benchmark 10-year government bond yield has resisted a sustained decline, signalling concerns that go beyond near-term liquidity.
Borrowing supply is heavy. The Centre, states, and public sector entities are all raising funds aggressively, while large redemptions push up gross issuance. In this environment, liquidity support can prevent disorderly tightening but cannot neutralise supply-demand imbalances. Elevated yields raise borrowing costs across the economy and complicate fiscal arithmetic, feeding back into monetary policy challenges.
Corridor management and fragmented liquidity
Another stress point lies in corridor management. Persistent deviations of overnight rates from the policy rate indicate that liquidity injections are not always translating into effective rate control. This weakens the RBI’s forward guidance and blurs the signal sent by policy decisions.
Compounding the problem is the uneven distribution of liquidity within the banking system. Reserve shortages are not uniform. Large banks often sit on surplus liquidity, while smaller or risk-constrained lenders struggle to access funds. The interbank market has not redistributed liquidity smoothly, reflecting heightened risk aversion and balance-sheet limits. This fragmentation helps explain why credit transmission remains patchy despite headline liquidity support.
A framework under strain
India’s inflation-targeting framework was built on assumptions of relatively stable capital flows and predictable liquidity conditions. Those assumptions no longer hold. Liquidity can tighten even as policy rates are cut, undermining transmission. Structural shifts have added complexity: digital payments have reduced cash float, households are moving savings from deposits to market-linked instruments, and regulatory liquidity norms have altered banks’ reserve behaviour.
As government bond supply rises and market volatility persists, the RBI is increasingly pulled into a dual role—liquidity provider and market stabiliser. Continuous balance-sheet management has become as important as rate setting, stretching the boundaries of monetary policy autonomy.
The challenge ahead is finely balanced. The RBI must keep liquidity supportive enough to sustain credit and growth, while preserving the credibility of its inflation mandate and avoiding the perception of fiscal backstopping. How it navigates this trade-off will define the next phase of Indian monetary policy.