New Delhi, Sept. 20 -- India's banking system has moved from a shortage of liquidity to an extraordinary abundance of it, leaving the Reserve Bank of India with a problem that central banks often find harder to solve than creating liquidity in the first place. Banking-system surplus liquidity touched a record Rs 11.6 lakh crore earlier this month before declining as tax outflows and foreign-exchange interventions removed some cash. The RBI has now turned to a powerful instrument rarely used for this purpose in recent years: outright sales of government securities through open market operations. It sold Rs 50,000 crore of bonds in the first tranche on September 17 and has scheduled further sales as part of a Rs 1 lakh crore programme. The return to auction-based bond sales after nine years is more than a technical adjustment. It signals that the central bank believes the surplus has become sufficiently persistent to require durable withdrawal rather than merely temporary parking of funds.
Excess liquidity is not inherently undesirable. Adequate cash in the banking system keeps money markets functioning, prevents sudden spikes in borrowing costs and gives banks room to support credit. The difficulty begins when there is far more money than the system requires. Overnight interest rates can then remain below the policy rate, weakening the RBI's ability to transmit monetary policy. Banks awash with funds also have less incentive to compete aggressively for deposits, while unusually easy financial conditions can complicate the fight against inflation. This explains why the RBI has simultaneously been using variable rate reverse repo auctions to absorb large quantities of cash. The objective is not to engineer a liquidity shortage, but to bring money-market conditions closer to the monetary-policy stance that the repo rate is supposed to represent.
The challenge lies in getting the pace right. Selling government bonds removes liquidity permanently, but it also adds securities to a market already absorbing substantial government borrowing. Aggressive sales can push bond yields higher, increase borrowing costs and eventually feed into the price of credit for businesses and households. Removing liquidity too slowly carries the opposite danger: monetary conditions remain easier than intended and any future policy-rate action loses some of its force. The RBI therefore has to navigate between two undesirable outcomes-allowing excessive liquidity to blunt monetary policy or withdrawing it so quickly that financial conditions tighten unnecessarily. The strong demand for the first Rs 50,000-crore auction gives the central bank some room, but does not eliminate this balancing act.
The repo rate may attract the headlines, but its effectiveness ultimately depends on whether market rates respond to it. India does not need a sudden monetary squeeze; nor should abundant liquidity become a permanent subsidy to easy money. The RBI's task now is to drain the excess gradually, predictably and with enough flexibility to respond to changing credit demand, inflation and global financial conditions. Having supplied liquidity when the system required support, it must now demonstrate the equally important skill of withdrawing it without unsettling growth.
Published by HT Digital Content Services with permission from Millennium Post.