The LIQUIDITY Conundrum

Last Friday, the yield on the 10-year bond dropped to its lowest level in three years. However, corporate bond yields and certificate of deposit rates have been rising. The spread, or interest rate differential between the repo rate and corporate bond yields, has recently widened to 125 basis points (bps), while the spread between central government securities and corporate/state government bonds has increased from 30–35 bps to 45–55 bps. (One basis point is a hundredth of a percentage point.) Bond prices and yields move in opposite directions.

Why is this happening despite a 25 bps rate cut by the Reserve Bank of India (RBI)? The answer is simple: A liquidity shortage in the Indian financial system.

The RBI has been doing everything a regulator can to manage liquidity. 

Today, on March 24, it will conduct a three-year, $10 billion dollar-rupee buy-sell swap auction. In such a swap, the RBI buys dollars from banks in exchange for rupees, with a commitment to sell the dollars back after three years. At the prevailing exchange rate, this will inject around Rs 86,000 crore into the system.

This follows a similar swap on February 28 and a six-month, $5 billion dollar-rupee buy-sell swap on January 19.

This is not the only instrument in the RBI’s toolkit to infuse liquidity. It has been conducting daily variable rate repo (VRR) auctions of different tenures. In such auctions, the RBI supplies money to banks at a market-determined rate.

Besides this, it has also been conducting OMOs, or open market operations, buying government bonds from banks and providing them with liquidity. In March, we saw Rs 1 trillion worth of OMOs in two equal tranches on the 12th and 18th.

Historically, there have been phases when liquidity in the system has been negative (sometimes by as much as a few trillion rupees). This happens when the regulator follows a tight money policy to fight inflation. A combination of rate hikes and tight liquidity makes money more expensive and slows down credit offtake.

There have also been occasions when the system was flush with liquidity. This happened in the financial year 2008–09 in the aftermath of the transatlantic financial crisis following the collapse of Lehman Brothers Holdings Inc. More recently, the system saw excess liquidity for a prolonged period after the Covid-19 pandemic, when the RBI launched an easy money policy.

The current situation is unique, as the RBI wants to push growth by cutting the policy rate, but the impact of the rate cut is not transmitting due to the liquidity shortage.

What are the sources of liquidity?

The cash reserve ratio (CRR) — a portion of banks’ net demand and time liabilities (a loose proxy for deposits) that commercial banks keep with the RBI without earning any interest — is the most potent tool for managing liquidity. In December, the RBI cut the CRR by 50 basis points to 4 per cent, releasing Rs 1.12 trillion into the system. However, there is limited scope to use this tool further, as the RBI Act sets a 3 per cent floor for the CRR.

OMO is another instrument. The RBI can buy bonds from banks to infuse liquidity or sell bonds to absorb excess liquidity. Since banks always hold more bonds than required to meet the statutory liquidity ratio (SLR), this is a frequently used tool.

Currency in circulation and surplus cash with the government are other factors influencing liquidity.

When the currency held by the public rises, it flows out of the system, tightening liquidity. This typically happens during festivals, when people keep more cash for spending.

Finally, money moves between the banking system and the government’s balance sheet, depending on whether the government is spending or holding cash in its coffers.

While these are ways to create (durable or temporary) liquidity or drain it, some methods come with side effects. Using a medical analogy, some tools act like antibiotics, which have unintended, and even intended, consequences. For instance, OMOs influence both liquidity and bond yields. There have been instances when the RBI used OMOs to manage bond yields rather than liquidity.

The healthiest source of liquidity is foreign fund inflows. In February, foreign institutional investors (FIIs) pulled out Rs 34,574 crore from the Indian stock market. This takes total outflows to Rs 1.12 trillion in the first two months of 2025 and Rs 2.12 trillion since October 2024.

FIIs and foreign portfolio investors (FPIs) bring in dollars and convert them into rupees to invest in India. Who buys these dollars? The RBI, through the banking system. For every dollar bought, an equivalent amount of rupees flows into the system. When these investors exit, they convert their rupees back into dollars, reducing liquidity.

Simply put, if FIIs and FPIs start investing in India again, liquidity concerns will disappear. The question is, when will they return? There are multiple reasons behind their exit, including overvalued equities, weak corporate earnings, and, until recently, more attractive returns in US markets. Another key factor is the sharp depreciation of the rupee until early March.

In five months between October 2024 and February 2025, the rupee depreciated by at least 4 per cent, from 83.81 to 87.50 per dollar. (The rupee closed at 87.50 a dollar on February 28, down from 83.81 a dollar on October 1.) When US bonds offer a risk-free 4.5 per cent return, why would foreign investors take on high currency risk in India?

Barring a few hiccups, the rupee had remained rock solid between 1998 (after losing value in the 1997 Asian currency crisis) and 2011. Before the crisis, in 1995, one dollar fetched Rs 34.43. By mid-August 1998, it was Rs 43.50; in 2011, Rs 43.85. Of course, there were fluctuations, such as in March 2009 (Rs 51.87 per dollar) and 2002 (Rs 49 per dollar), but overall, the currency was highly stable for over a decade.

The rupee strengthened to Rs 85.98 per dollar last Friday. Once it finds an equilibrium, foreign investors will be encouraged to bet on India again, as the risk of large currency depreciation will fade. Until flows resume, the RBI will have to manage liquidity.

How much liquidity do we need? “Appropriate,” “adequate,” or “abundant”? To stimulate economic growth, adequate liquidity must complement the rate cut.

The central bank has little choice but to expand its balance sheet to create sufficient liquidity. If done through OMOs, the RBI’s rupee balance sheet will grow; if done via dollar-rupee buy-sell swaps, its foreign currency balance sheet will expand.

Such swaps are essentially a way of borrowing dollars for the tenure of the transaction. In the first leg, dollar purchases inject liquidity; in the second leg, selling those dollars absorbs liquidity. The RBI can, however, choose not to sell the dollars at the second leg and instead roll them over, as it has been continuously doing.

In January, of India’s $640 billion in foreign exchange reserves, $82.6 billion were in the form of short-term buy-sell swaps. This means the RBI has deferred rupee liquidity withdrawal worth around Rs 7.5 trillion through these swaps.

With the dollar index falling from 110 to around 104 and the rupee strengthening from its recent low (87.90 to 85.98), a combination of long-term dollar-rupee swaps and OMOs could be the best strategy for liquidity infusion.

This is crucial because, even if the RBI implements another rate cut in April, it will not have much impact for most borrowers unless there is sufficient liquidity in the system. The RBI would do well to provide adequate liquidity after accounting for liquidity reduction due to the maturing of the existing buy-sell swaps.

The author, a Consulting Editor of Business Standard, is a Senior Advisor, Jana Small Finance Bank.

This column first appeared in Business Standard

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