RBI, money creation, and govt finances: Why non-bank debt will matter ahead

Large transfers and bond buys by the Reserve Bank of India have supported fiscal maths and liquidity; sustaining this when inflation or capital flows shift may prove harder

Alongside helping navigate monetary policy, liquidity, and currency and bond markets, record open market operation (OMO) bond purchases and dividend transfers of the Reserve Bank of India (RBI) have helped the government’s fiscal arithmetic, while keeping yields low. Moderate inflation has made all this possible, though with implications for the external balance. What happens when the cycle turns?

 

Money creation: There are four ways through which money supply (M3) is created, across currency in circulation, and banking demand and time deposits.

 

First, when a bank extends a commercial loan, it credits funds to the borrower’s account, creating money. Contrary to what intuition might suggest, banking loans create deposits, not the other way around.

 

Second, when the banking system, including the RBI, funds the government by purchasing bonds, the resulting government spending injects fresh money into the economy.

 

Note that when households and non-bank investors extend finance, money only shifts from one holder to another without expanding aggregate money supply. Financing by the banking system and the RBI creates fresh money; financing by non-banks does not.

 

Third, when foreign currency flows into the country and is converted into rupees, fresh money is created.

 

Finally, when banks (including the RBI) pay dividends out of their reserves, this eventually results in money creation.

 

Money once created is then free to circulate and add to consumption, as well as to external demand, and consumer and asset price inflation.

 

Money is removed when each of the above reverses, i.e., when loans are repaid to banks, when the government cuts spending financed by banks and the RBI, when there are foreign currency outflows, or when banks raise capital from non-banks.

 

RBI dividends— scale and justification: The scale of recent dividend transfers from the RBI to the government is significant. For FY25, the RBI transferred ₹2.69 trillion to the Government of India (0.75 per cent of gross domestic product), following a ₹2.11 trillion transfer the prior year. These are amongst the largest central bank-to-government transfers globally. While they serve as vital non-tax revenue, reducing both revenue and fiscal deficits, their composition deserves scrutiny.

 

Part of this income is structural to central banking. Interest earned by the RBI on foreign assets (around ₹1 trillion in FY24), effectively funded by non-interest-bearing liabilities such as currency in circulation and banking balances with the RBI, represents one source of this income.

 

Other components, however, require some interpretation.

 

Interest earned by the RBI from its large holding of government bonds, net of the costs borne in absorbing excess banking liquidity, reached ₹0.9 trillion in FY24. Repeated recycling of large government interest payments back to the government through RBI dividends can, at the margin, blur the boundary with indirect monetisation.

 

The trickiest aspect involves foreign exchange gains. When foreign currency originally purchased by the RBI at a low price is sold back to the market at a higher price, the difference represents realised profits for the RBI, and a reduction in money supply. Any transfer of this profit to the government, and its spending, reverses the monetary contraction. That offers some justification for the RBI paying out such realised gains as dividend.

 

In FY24, the RBI recognised ₹0.8 trillion in exchange gains. However, during FY24, the RBI was a net purchaser of $41 billion in the spot market. The recognition of net foreign exchange gains in FY24, despite net foreign currency purchases, arises from the RBI’s accounting methodology. Gains are recognised on gross spot market sales ($153 billion) against historical weighted average costs, while gross market purchases ($194 billion) increase the average holding cost of the reserves. This allows the RBI to harvest valuation gains, even when there is no concomitant reduction in money supply.

 

Even in FY25, when the RBI sold a net $34 billion in spot markets and $84 billion in forward markets, it harvested accounting gains on gross sales of $399 billion in the spot market. Overall, every rupee of dividend paid by the RBI, however justified, has a monetary impact.

 

The current monetary snapshot: The RBI Broad Money report as of January 2026 shows that money supply (M3) is up 12 per cent year-on-year, at the upper end of the range of the past few years. This is driven by growth in commercial credit (up 14.1 per cent). However, the RBI plays a key role in the 12 per cent rise in bank credit to the government. The RBI’s OMO purchases during FY26 reached a high of ₹6.4 trillion by January 2026, offsetting the money drain caused by net FX outflows.

 

Across record OMOs and dividend transfers, the RBI has materially eased monetary conditions and interest rates in FY26. At a time of low inflation, this has bridged the gap between the government’s borrowing needs and the market appetite for bonds. However, this easing has also added to the pressure on the rupee, given the well-known impossible trinity.

 

Takeaways: In a less favourable environment, the RBI may not be able to deliver a similar magnitude of OMOs and dividends and keep yields low, without risking adverse macroeconomic and market impact.

 

The RBI is not any regular cash-rich public sector undertaking (PSU). As a central bank, every bond it purchases and every rupee of dividend it distributes, however strong or weak the justification, impacts money supply, interest rates, consumer and asset inflation, and external balance.

 

Two structural shifts are now essential.

 

First, India must deepen its fixed-income markets. Incentivising greater household and non-bank participation in fixed-income markets will allow financing of government and commercial debt without creating new money, enhancing policy flexibility. For policymakers, injecting money is an easier sell than withdrawing it.

 

Second, it is imperative that revenue deficits are further reduced. Large central bank transfers currently significantly compress the headline revenue deficit, masking underlying pressures.

 

Macroeconomic resilience will be enhanced when borrowers and the government reduce their reliance on banks and the RBI for financing. When the inflation cycle turns, the RBI’s support may have to recede much faster than expected.

The writer is a former whole-time member, Sebi.

 

The views are personal