RBI to Drain Liquidity Amid Looming Rate Hikes

Indian bond traders anticipate the Reserve Bank of India (RBI) will soon drain significant surplus liquidity from the banking system. This expected move aligns with the central bank’s preparations to tighten monetary policy amidst rising inflation risks.

The banking system has seen a substantial liquidity surge, averaging over 3.4 trillion rupees ($36 billion) in August. This increase largely stems from Indian banks raising foreign currency non-resident (FCNR) deposits, which were then swapped with the RBI under a temporary scheme.

Key liquidity figures:

• Average banking system liquidity surplus in August: over 3.4 trillion rupees ($36 billion)
• FCNR deposit scheme attracted: $65 billion between June 5 and August 21
• Anticipated bond redemptions: over 630 billion rupees within the next fortnight
• Projected surplus liquidity in September: above 5 trillion rupees

RBI’s Anticipated Liquidity Tools

To manage this expanding surplus, the RBI is likely to deploy a range of longer-duration instruments to withdraw liquidity. Treasury officials suggest several potential measures for the central bank.

• Three-month variable rate reverse repo (VRRR) auctions: These could include an early-reversal option, as suggested by Abhishek Upadhyay, co-head of research at ICICI Securities Primary Dealership.
• Foreign-exchange sell/buy forward swaps: Similar maturities to the VRRR auctions are also a possibility, according to Upadhyay.
• Raising banks’ incremental cash reserve ratio (CRR): This would require banks to set aside a larger portion of new deposits as reserves, though it currently does not apply to FCNR deposits from the special window.

While the RBI maintained its interest rates and policy stance earlier this month, recent meeting minutes revealed discussions among rate panel members regarding potential rate hikes later in the year. Tighter banking system liquidity conditions typically lead to higher short-term borrowing costs and policy interest rates.

This encourages banks to pass on monetary tightening to consumers and businesses. Alok Singh, head of treasury at CSB Bank, noted a greater than 50% chance of longer-duration VRRRs being implemented. An interim CRR increase, he added, would likely only occur if inflation reaches 6%.