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Over the past few months, the Reserve Bank of India (RBI) has begun addressing both frictional liquidity and durable liquidity needs. This has raised hopes that RBI could be closer to cutting interest rates in the February policy. The key question to ask is if the liquidity measures are enough to ensure transmission of potential rate cut going forward. To answer this, we will need to assess what is the level of liquidity which will enable better transmission and how far we are from those levels.
RBI’s frictional liquidity measures which consist of short-term variable rate repo (VRR), have ensured that overnight rate remains close to repo rate despite large liquidity deficit. While this measure has been effective in keeping overnight rates contained, it can’t support credit off-take.
Durable liquidity infusion is key to support credit creation by aiding deposit growth. Since financial year 2023 (FY23), bank credit growth has outpaced deposits, resulting in credit-to-deposit ratio rising to 80 per cent. We are now seeing bank credit growth moderation, as deposit growth is unable to keep pace.
Over the last few months RBI has begun to address durable liquidity by deploying various instruments. Starting with the Cash Reserve Ratio (CRR) cut in December 2024, which infused Rs 1.16 trillion of liquidity. On January 27, 2025, RBI unveiled measures which will infuse Rs 1 trillion durable liquidity spread over January-end to February. These include Open Market Operation (OMO) purchase auctions worth Rs 600 billion and $5 billion USD-INR buy-sell swap. Under OMO, RBI buys government securities to infuse liquidity. Under buy-sell swaps, RBI buys dollars to infuse liquidity in the spot leg.
Are the above measures enough to create an environment conducive to transmission? The short answer is no. Currently, core liquidity which is the sum of banking system liquidity and government cash surplus is negative at –Rs 0.8 trillion as of January 17, 2025. Negative core liquidity means that even if the government spends its entire cash surplus, banking system liquidity will remain negative.
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This is a drastic change from a few months back when core liquidity was a substantial surplus at Rs 4.6 trillion as of September 27, 2024. The swing from surplus to deficit was led by balance of payments turning deep negative from Q3FY25 onwards with outflows in both FPI and FDI. The negative balance of payments implies that capital inflows are not enough to fund the current account deficit, forcing the RBI to bridge the gap by selling dollars. The substantial dollar sales by RBI have drained banking system liquidity by Rs 3.9 trillion in FYTD25 (Apr- January 17th).
Even after incorporating the recently announced measures, core liquidity deficit will continue to rise due to currency leakage from the banking system. Hence more durable liquidity infusion will be needed to ensure that when RBI does cut interest rates, it is transmitted by the banking system.
Our analysis shows that additional liquidity infusion of Rs 2 trillion is needed by March 2025 and further Rs 1 trillion infusion in FY26. We have considered the RBI dividend remaining substantial in FY26 at Rs 2 trillion and a small balance of payments surplus.
RBI transfers the dividend in May to the government, which works as a liquidity infusion. The improvement in balance of payments assumes pick-up in Foreign portfolio investment (FPI) and foreign direct investment (FDI) inflows in FY26, as markets get more clarity on President Trump and Fed policy.
An unknown source of liquidity drain is RBI’s forward book where there has been a substantial build-up in dollar short positions. As of November 2024, net dollar shorts totalled $58.8 billion. The build-up of dollar short positions took place as RBI tried to reduce the drain on banking system liquidity from FX intervention. Not all of the dollar short positions will result in liquidity drain on maturity, as some of these are NDFs.
Moreover, some part of the forward book will be rolled over. Despite liquidity conditions still being tight, when the RBI meets in February, we still expect policy rates to be cut. This is because it takes time for rate cuts to work their way through the economy. Growth conditions are showing signs of softness with three factors exerting downward pressure. These include a slowdown in credit impulse, decline in general government capex and tight monetary policy.
The impact is visible on urban demand and capex cycle, both of which have lost some momentum in H1FY25. At the same time, the inflation outlook has turned favourable with food inflation showing broad-based moderation.
The policy rate cuts will need to be augmented with additional liquidity infusion measures. Given the quantum of liquidity infusion required, we expect more OMO purchases and USD-INR buy-sell swaps to be announced. We don’t rule out a potential CRR cut, given the extent of liquidity infusion required.
The author is Chief Economist, IDFC First Bank, Economist Unit
Disclaimer: These are the personal opinions of the writer. They do not reflect the views of www.business-standard.com or the Business Standard newspaper
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