RBI’s Rs 14.6 lakh crore cash shield: Why bond purchases alone won’t save the rupee

However, interest rates do not move solely with liquidity conditions. Demand and supply in the bond market, expectations around economic growth and inflation, Government borrowing requirements, fiscal conditions and overall market sentiments also influence the direction of rates. Liquidity is therefore an important part of the monetary policy transmission mechanism,

RBI’s proactive approach to liquidity

The RBI has been proactive in managing system liquidity, particularly as the financial system has faced persistent liquidity pressures over the past two years. These pressures have stemmed from slower deposit mobilization relative to credit growth, foreign exchange outflows, rising currency in circulation (CIC), RBI’s foreign exchange interventions, and the maturity of forward positions.

Importantly, the RBI started taking steps to ease liquidity conditions as early as December 2024, well ahead of the subsequent rate-cut cycle. The objective was to ensure adequate system liquidity, support credit growth, and facilitate the transmission of monetary policy easing.

The scale of liquidity support increased significantly in FY2025-26.

RBI’s liquidity measures

Open Market Operation (OMO) purchases of Rs 8.28 lakh crore in FY2025-26 alone were equivalent to almost half of the year’s gross market borrowings. This highlights the significant role played by the RBI in supporting market liquidity and maintaining orderly conditions in the government securities market.

But liquidity pressures are not always domestic

While the RBI has provided substantial domestic liquidity, the nature of the challenge has also evolved. The West Asia crisis brought external pressures to the forefront.

Higher crude oil prices increased India’s import bill and widened the trade deficit, while heightened global risk aversion led to foreign investor outflows. Together, these factors put pressure on the Rupee.

A weaker rupee and higher import costs can increase pressure on the balance of payments and forex reserves. At the same time, RBI intervention in the foreign exchange market to smooth excessive currency volatility has withdrawn rupee liquidity from the domestic financial system.

This creates a difficult balancing act for the RBI. When liquidity pressures are driven by foreign exchange outflows, conventional measures such as OMO purchases may address the domestic liquidity shortage but do not directly address the underlying external pressure. This becomes even more important when domestic credit growth is already strong.

Looking beyond OMOs

Against this backdrop, the RBI has also focused on attracting stable and longer-term foreign currency inflows.

One of the key measures has been the revival of the (Foreign Currency Non-Resident (Bank) Deposit) FCNR(B) deposit scheme, encouraging NRIs to place foreign currency deposits with Indian banks for 3–5 years.

Historically, the key challenges for FCNR(B) deposits have been currency depreciation risk for depositors and the cost of hedging for banks. The RBI’s measures to support hedging costs and exempt these deposits from Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) requirements have improved the attractiveness of the scheme.

The RBI has also allowed Public Sector Undertakings (PSUs) to raise External Commercial Borrowings (ECBs) and overseas foreign currency borrowings, with support towards hedging costs. These inflows are relatively stable, as the funds are generally locked in for 3–5 years.

Strong response to the measures

The response to these measures has been significantly stronger than anticipated. The RBI has decided to close the FCNR(B) window on 31 August 2026, ahead of the original deadline of 30 September 2026.

The forex inflows till August 21, 2026 mobilised through these channels have been substantial –

The recent experience highlights that liquidity management is not simply about injecting rupee liquidity into the banking system. During periods of external stress, ensuring adequate foreign currency liquidity can be equally important.

Way ahead

With surplus banking-system liquidity supporting credit growth and stronger foreign-currency inflows easing external pressures, the RBI faces a more complex policy trade-off amid rising inflation risks arising from the West Asia crisis. While liquidity remains broadly neutral, any renewed inflationary pressure could prompt the RBI to first absorb excess durable liquidity before resorting to a rate hike.

In this context, OMO sales may be less attractive given their potential impact on bond yields and the Government borrowing programme. With CRR already at 3%, there may be some scope for further adjustment, while longer-tenor Variable Rate Reverse Repo (VRRRs) could also be used to absorb surplus liquidity. However, their effectiveness would depend on adequate bank participation. Thus, liquidity management is likely to remain in the RBI’s first line of response, with rate hikes coming into consideration only if inflationary pressures become more persistent.

About the Author: Mansi Kariya is Associate Vice President & Fund Manager- Debt, PPFAS Mutual Fund. She joined PPFAS Mutual Fund in 2018 as a Debt Dealer. Gradually, she assumed the role of Credit Research Analyst within the Fixed Income Team and then eventually became a Fund Manager – Debt. In her previous roles, Mansi has worked as a research associate and senior executive – debt products for 3.5 years. She has a B.Com Hons from Calcutta University, MS Finance from ICFAI University, and is also a CFA Charterholder.

Disclaimer:
Views expressed are based on information available as on the date of publication and are subject to change. This note is intended solely for informational purposes and should not be construed as an investment advice, a recommendation or a forecast of future events. Readers should exercise their own judgment and seek professional advice before making any investment or financial decisions.

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