Managing excess liquidity: Financial markets need more clarity now

Liquidity conditions in Indian banking have undergone a significant change over the last few quarters. While the system was in a deficit of about ₹2 trillion at the end of 2024, it now records a daily surplus of over ₹3 trillion, rising to ₹4 trillion on some days. Central banks sometimes keep the system in deficit or surplus to attain monetary policy objectives, but an excess on either side could lead to unintended consequences. The Reserve Bank of India (RBI), for instance, faced criticism for the liquidity deficit in recent quarters, which partly resulted from its intervention in the currency market to support the rupee, pushing up market interest rates. However, the situation changed as the pressure on the rupee abated and the inflation rate turned favourable. 

As RBI Governor Sanjay Malhotra’s June 6 monetary policy statement noted, the central bank had injected durable liquidity worth ₹9.5 trillion since January. The central bank also decided to reduce the cash reserve ratio (CRR) by 100 basis points, to be implemented in four tranches, which will add  liquidity worth ₹2.5 trillion to the system. As a result, some economists are of the view that excess liquidity in the system could go up to ₹5 trillion later this year. While the liquidity deficit pushes up money-market rates and lending rates in general, surplus liquidity can have the opposite effect. Excess liquidity in the system can increase inflationary risks. Although India is in a comfortable position on inflation, based on the Consumer Price Index, for the foreseeable future, excess liquidity can fuel asset-price inflation. Banks, for example, have cut savings deposit rates, among other rates, which might prompt savers to shift funds to high-yielding assets. 

Excess liquidity could also incentivise the banking system to extend loans at lower rates. As a report in this newspaper showed, many market participants were surprised that a public-sector entity was recently given a ₹1,000 crore loan at just 6.1 per cent, which is close to the cost of funds. Easy availability of funds can also prompt some banks to extend loans to entities that may not otherwise qualify. However, it is worth noting that a lower policy rate or excess liquidity may not by itself push bank credit for a variety of reasons. There is significant global uncertainty, which will affect investment decisions in the private sector. Further, corporations are raising more funds from the capital market. As the latest Financial Stability Report of the RBI showed, resource mobilisation through capital markets increased 32.9 per cent in 2024-25, and over 60 per cent was in the debt segment. The year witnessed the highest corporate bond issuance worth about ₹10 trillion. As the debt market gains depth, higher-rated corporations will likely find it more attractive to raise funds from the debt market than from banks. Thus, competition could compress net interest margins in the banking system. 

In terms of liquidity management, while the RBI is conducting variable rate reverse repo auctions, the weighted average call rate — the operational target of monetary policy — is trading well below the policy rate. The RBI may intend to keep things this way for some time to enable the transmission of its recent policy decisions. However, it will need to do more to manage excess liquidity in the system, especially as more liquidity is expected to be released owing to the CRR reduction. It would also do well to communicate to the market the level of excess liquidity it intends to maintain.