In a significant pre-policy consultation with the Reserve Bank of India, economists and treasury officials have delivered a clear message to the central bank. The consensus among market participants is that addressing the liquidity crunch in the banking system should take precedence over any further interest rate reductions in the upcoming monetary policy review.
Liquidity Takes Center Stage
With growth and inflation appearing relatively stable, the discussion during the meeting focused squarely on tools to alleviate persistent liquidity strains. These pressures have emerged from multiple factors including the RBI's ongoing intervention in foreign exchange markets to manage rupee volatility, robust credit growth across sectors, and substantial advance tax outflows from the system.
The banking system liquidity deficit stood at approximately ₹60,000 crore as of January 21, highlighting the urgency of the situation. Market participants emphasized that durable liquidity solutions are now more critical than temporary measures.
Preferred Instruments for Liquidity Infusion
Participants expressed strong preference for continued utilization of open market operations and dollar buy-sell swaps as primary instruments for injecting durable liquidity. There was notable consensus that these tools offer more sustainable relief compared to short-term mechanisms like variable-rate repo operations.
Regarding OMOs, while many advocated for increased bond purchases to inject rupee liquidity, some cautioned about practical limitations. Banks' ability to sell securities remains constrained by liquidity coverage ratio requirements, potentially limiting the effectiveness of OMO purchases if financial institutions are reluctant or unable to part with their holdings.
One innovative suggestion involved the RBI publishing an indicative OMO calendar for the next financial year, potentially outlining purchases up to ₹5 trillion, to provide much-needed predictability to market participants.
Addressing Dollar Funding Stress
The discussions also highlighted emerging dollar funding stress, with several participants identifying buy-sell swaps as particularly effective and flexible tools. Some suggested the RBI could announce another tranche of long-tenor swaps, potentially in the range of $5-10 billion, to reassure markets ahead of the March-end balance sheet tightening period.
Additional proposals included longer-term variable-rate repos, as short-duration VRRs were seen as offering only transient relief, and even the possibility of targeted long-term repo operations. A few participants raised the option of a temporary 1% reduction in the cash reserve ratio if liquidity pressures persist, though others noted that with CRR already at 3%, the central bank might prefer to preserve this tool for more acute crises.
Broader Economic Context
Concerns about the government's substantial borrowing program also surfaced during the discussions. Combined central and state borrowing next year is expected to reach approximately ₹30 trillion, underscoring the critical need for supportive liquidity management to accommodate this significant debt issuance.
On the currency front, participants advised the RBI to minimize verbal intervention regarding the rupee, emphasizing that concrete actions would be more valuable than commentary. This recommendation comes as the rupee recently touched a fresh record low of 91.7450 against the dollar, driven by geopolitical concerns and foreign portfolio investor outflows.
Rate Cut Effectiveness Questioned
The emphasis on liquidity tools over rate cuts reflects growing concerns about monetary policy transmission. Despite 125 basis points of rate reductions in 2025, government bond yields have actually risen rather than fallen. Since last month's 25 basis point cut announcement, the yield on the 10-year benchmark government bond has increased by 13-15 basis points to reach 6.63%.
Financial institutions like MUFG Bank have noted that capital outflows, foreign exchange intervention to contain rupee weakness, and elevated state government borrowing are collectively hindering the transmission of RBI's rate cuts through the broader interest rate structure.
The Monetary Policy Committee is scheduled to meet from February 4-6 for what will be its final policy review of the current financial year. Market participants widely expect the rate-setting panel to maintain the current policy stance, focusing instead on liquidity management tools to address systemic pressures.
