The Reserve Bank of India's (RBI) recent efforts to bolster foreign currency reserves have inadvertently created a significant liquidity problem within the Indian banking system. According to Prasanna Tantri, Associate Professor of Finance at the Indian School of Business (ISB), India's liquidity surplus has surged to approximately ₹11.6 lakh crore (roughly 3% of GDP), a dramatic increase from just ₹2–3 lakh crore a fortnight earlier.
RBI's Dollar Inflow Strategy
In June, the RBI introduced a special USD-rupee swap facility targeting fresh FCNR(B) deposits with maturities of three to five years. This mechanism allowed banks to raise dollar deposits from Non-Resident Indians (NRIs) and then swap these dollars with the central bank. Additionally, eligible fresh FCNR(B) deposits were exempted from Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) requirements, making them more attractive to banks.
By August 31, the broader concessional swap facility had mobilized about $136.4 billion, with FCNR(B) deposits alone contributing approximately $127.2 billion. While successful in attracting foreign currency, this influx of dollars simultaneously released a substantial amount of rupees into the domestic banking system, creating the current liquidity surplus.
Professor Tantri's Concerns and Warnings
Professor Tantri has raised several critical concerns regarding this strategy. He argues that the RBI must now absorb this excess rupee liquidity carefully to prevent weakening its control over short-term interest rates and potentially fueling inflation. He questioned the policy's efficacy, suggesting it functions as an indirect subsidy for foreign investors.
"If the objective was to make Indian assets more attractive to foreign investors, why not simply cut capital-gains taxes?" Tantri asked, suggesting such a move would be a "transparent subsidy with a clear fiscal cost," unlike the current "complicated and indirect subsidy."
Proposed Solutions and Criticisms
Tantri advocates for a durable mechanism to absorb the surplus, rather than treating it as a temporary issue. His preferred option is the Market Stabilisation Scheme (MSS), where securities are issued and the proceeds are impounded. He acknowledges that this incurs an interest cost, which he views as the necessary cost of sterilizing liquidity created by the policy intervention. He firmly opposes using the Cash Reserve Ratio (CRR) to force banks to absorb liquidity, as banks earn no interest on CRR balances.
Banks have already shown little interest in short-duration absorption, with a 30-day operation being heavily undersubscribed. This indicates banks are not willing to lock up large amounts of money at the prevailing rate of 5.24%, signaling a price issue rather than a credibility problem.
Winners and Risks
According to Tantri, the "clear winners" of this arrangement are NRIs and Foreign Portfolio Investors (FPIs). NRIs benefit from unusually high returns with exchange-rate protection, while FPIs can exit at a stronger rupee without their selling significantly depreciating the currency. "The public balance sheet absorbs the costs and future risks," he noted.
Another potential way for the excess liquidity to disappear is through FPI withdrawals. FPIs have already withdrawn approximately ₹15,000 crore since September 1. Tantri suggests that RBI support for the rupee allows FPIs to sell without substantially worsening their exit price. However, if the RBI supplies dollars to meet this demand, it drains the central bank's foreign-exchange reserves, potentially leaving India with increased external liabilities and merely shifting risks to the future.
Tantri also cautioned against forcing banks to lend their excess cash, warning that there isn't enough bankable demand to absorb such a massive additional lending quickly. He invoked the 2008 global financial crisis model, cautioning that today's liquidity problem could easily become tomorrow's bad-loan crisis if handled improperly. Instead, the RBI should offer a durable instrument at a price banks are willing to accept.