The Reserve Bank of India is faced with an unusual monetary-policy headache: there is simply too much money, or liquidity, in the banking system, with banking-system liquidity climbing to a four-year high of about Rs 9.7 lakh crore on September 2, the highest level since May 2022.

Foreign-currency inflows through the recent swap facility on a large scale, combined with the liquidity released through the RBI’s foreign-exchange operations, have resulted in a huge pool of rupee funds chasing relatively limited avenues for deployment. While core liquidity is close to Rs 10 lakh crore, the daily average surplus stood at Rs 3.67 lakh crore in August, more than three times July’s Rs 1.07 lakh crore, said Sneha Pandey, fund manager, Equity, Quantum AMC.

The central bank must now drain this excess liquidity without triggering a sharp rise in interest rates or unsettling the government securities market. Huge liquidity in the banking system generally puts downward pressure on overnight money-market rates, potentially pushing them below the repo rate unless the RBI actively absorbs the excess liquidity. Persistently loose liquidity conditions can also add to inflationary pressures.

The unusual situation has come at a time when global central banks are keeping rates high or tightening cautiously to curb inflation, and members of the RBI’s Monetary Policy Committee have indicated that, as headline inflation is projected to peak at as high as 5.9% in Q3 2026-27, a “case for a hike may emerge” during the course of the year.

“Even after adjusting for the increase in currency in circulation during the upcoming festive season and the maturity of the RBI’s short dollar positions in the forward markets, we expect core liquidity to rise from Rs 8.1 lakh crore as of mid-August to potentially closer to Rs 13-14 lakh crore by December-end in the absence of any liquidity management operations by the RBI,” CareEdge Ratings said.

“Given the swap arrangement, these inflows will add to an already abundant rupee liquidity backdrop, which was at a four-year high this month, depressing overnight rates,” DBS Bank Senior Economist and ED Radhika Rao said.

The deluge was created as the RBI’s special US dollar-rupee forex swap facility drew foreign-exchange inflows of $136.377 billion through August 31. FCNR(B) deposits accounted for the overwhelming share of the mobilisation at $127.226 billion. “These dollars, when converted, released rupees into the system, and the exemption of these deposits from CRR and SLR meant the liquidity landed unencumbered,” said a fund manager.

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Beyond strengthening the capital account and the overall balance of payments, these sizeable inflows are also likely to add significantly to domestic liquidity. However, some of this impact could be offset by seasonal currency demand and the RBI’s maturing forward book. “We estimate that currency in circulation (CiC) could rise by around Rs 1.1 lakh crore from June levels by December amid the seasonal uptick during the festive period,” CareEdge Ratings said.

Further, the maturity of the RBI’s short positions in the forward market could create an additional liquidity drag of around Rs 3 lakh crore, with about $22 billion of the short-forward book maturing within three months. CRR accretion arising from deposit growth should further reduce core liquidity by Rs 70,000 crore.

RBI tools to manage excess money

Global central banks are mostly planning to keep rates high or tighten cautiously because inflation, especially from energy and geopolitical shocks, remains above target despite weakening growth. The RBI cannot afford to leave liquidity excessively loose if that begins to add to inflationary pressures and pushes market rates too far below the policy rate.

Rao said concerted steps will be required to drain the potential surge in liquidity. “Near-term options include a temporary Cash Reserve Ratio (CRR) hike or an Incremental CRR, as introduced in 2023. While this will have an immediate impact, such a move could be viewed as effectively unwinding the RBI’s earlier decision to exclude these deposits from CRR and SLR requirements,” Rao said.

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The RBI has, in the past, used multiple tools to drain excess liquidity from the system, depending on the circumstances, with varied implications for the bond and forex markets. “In the current context, the RBI may initially deploy a mix of liquidity management tools, including longer-tenor VRRR operations and OMO sales, to absorb the emerging surplus liquidity. These measures could be followed by more liquidity-absorption tools such as the Incremental Cash Reserve Ratio (I-CRR) if the surplus proves persistent,” CareEdge said.

The first line of defence is already in play. “The RBI has been running back-to-back Variable Rate Reverse Repo (VRRR) auctions, including a 7-day Rs 6 lakh crore operation and an overnight Rs 4 lakh crore operation on the same day, followed by Rs 5 lakh crore and Rs 6 lakh crore overnight operations on successive days,” Pandey said.

On paper, raising the CRR is the cleanest way to extract durable liquidity. At 3.00% of NDTL today, after last year’s 100 bps cut, the RBI has ample room to lift it, and absorbing liquidity equivalent to 2% of NDTL through the CRR would drain a very large and durable quantum from the system, Pandey said.

Open market operations, or OMO sales, are the calibrated middle path, reversible in principle, market-priced and stance-neutral if communicated well. Having injected Rs 2 lakh crore of durable liquidity through OMO purchases only last winter, the RBI can comfortably run the operation in reverse now.

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To that extent, if the central bank continues to gradually sell dollars in the spot market, while allowing the forward-book shorts to mature, this will also help reduce excess liquidity by late FY27. It will also be important to determine whether the central bank tightens policy in H2FY27, in which case overall liquidity will have to be tightened to steer call rates towards the repo rate.