India's banking sector is currently experiencing an unprecedented surge in liquidity, with the system's surplus reaching an all-time high of nearly ₹10.5 trillion. This significant influx of funds has been primarily driven by a special program that attracted a record $127 billion from the vast Indian diaspora.
The substantial dollar inflows have created a "surfeit of rupee liquidity," as noted by financial experts. This has, in turn, pushed the overnight interest rate in the money market below the Reserve Bank of India's (RBI) benchmark rate. Such a scenario complicates the central bank's monetary policy objectives, making it more challenging to manage inflation and maintain financial stability.
RBI Faces Liquidity Management Challenge
Economists anticipate that the Reserve Bank of India will need to intensify its efforts to absorb this excess liquidity from the banking system. Barclays Bank economists, in a recent note, suggested that the RBI is likely to deploy a combination of measures.
These expected actions include continued variable reverse repo rate (VRRR) operations and potentially an incremental cash reserve ratio (ICRR) hike. VRRR operations are a tool used by the RBI to absorb short-term liquidity from banks by lending them government securities in exchange for funds.
No Permanent Measures Expected Soon
While temporary measures are on the horizon, Barclays economists do not foresee the RBI implementing permanent liquidity absorption tools in October. This means that a standard cash reserve ratio (CRR) hike without a sunset clause, open market operations (OMO) sales, market stabilization scheme (MSS), or a direct policy rate hike are not expected in the immediate future.
Suyash Choudhary, CIO for fixed income at Bandhan AMC, echoed the sentiment that the RBI may need to act swiftly. He emphasized the necessity of deploying both temporary and more permanent measures for liquidity absorption, stating, "sooner rather than later."
Restoring Policy Rate Anchor
Choudhary explained that the heavy diaspora inflows have led to money market conditions loosening considerably, pulling average overnight rates significantly below policy rates. The immediate priority for the RBI, he suggested, would be to restore the overnight rate as the anchor for policy rates.
Following this initial step, the central bank would then need to address the absorption of medium-term excess liquidity. This process is crucial as the Monetary Policy Committee (MPC) also considers the appropriate pace of repo rate normalization amidst rising inflationary pressures.
Additional factors such as an expected increase in currency in circulation during the festive period (September-November) and potential foreign exchange interventions could also contribute to taking out some liquidity from the system.