India's Banking System Liquidity Deficit And RBI's Measures

India’s banking system is grappling with a liquidity deficit, reaching ₹3.13 lakh crore as of January 27, 2025. To address this challenge, the Reserve Bank of India (RBI) has initiated several liquidity measures, alongside monetary policy adjustments to ensure stability and growth.

Key Actions Taken

Bond Purchases: The RBI will conduct government bond buybacks worth ₹60,000 crore in three tranches on January 30, February 13, and February 20, 2025.
- This involves purchasing government securities from banks, infusing cash directly into the banking system.
- Impact:
  - Provides immediate liquidity to banks, aiding them in meeting short-term obligations and increasing lending capacity.
  - Lowers borrowing costs by reducing yields in the bond market due to increased demand.
  - Boosts market confidence by ensuring adequate cash reserves in the system.
Repo Auction: A 56-day variable rate repo auction worth ₹50,000 crore will be conducted on February 7, 2025.
- This allows banks to borrow funds by pledging eligible securities as collateral for a longer duration.
- Impact:
  - Eases short-term borrowing pressures by providing predictable and sustained liquidity.
  - Stabilizes overnight and short-term lending rates, reducing elevated costs caused by the liquidity crunch.
  - Supports ongoing credit requirements, particularly in sectors facing cash flow challenges.

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Variable Rate Repo Auction:

Also called Term Repo Rates, It is a liquidity injection tool of the RBI for liquidity management in the economy.
VRR Auctions: They are conducted by the RBI, when the weighted average call money rate trends above the repo rate in the interbank money market, serving as a signal to the RBI of System Liquidity Deficit.
Tenure: It is a short term liquidity injection against collaterals with a tenor of Overnight to 13 days usually.
- But, for injection of durable liquidity, the RBI conducts VRR auctions for a tenor beyond 14 days very rarely.
Rate of Interest: It generally is borrowed at a rate decided by market generally lower than Repo Rate (though not less than Reverse Repo Rate).

Currency Swap:
- A USD/INR buy/sell swap auction worth $5 billion is set for January 31, 2025, with funds entering the system on February 4.
- Mechanism:
  - RBI will buy dollars from banks, injecting an equivalent amount of rupee liquidity into the system.
  - After six months, the swap will reverse, with banks repurchasing dollars and returning rupees to the RBI.
- Impact:
  - Injects approximately ₹43,000 crore into the banking system, alleviating liquidity pressures.
  - Stabilizes foreign exchange reserves and reduces excessive volatility in USD/INR rates.

About Liquidity Deficit

A liquidity deficit in the banking system occurs when banks don’t have enough cash to meet customer demand for credit.
This can happen when banks borrow more money from the Reserve Bank of India (RBI) than they lend.

Reasons for Liquidity Deficit

High credit demand: Increased borrowing by businesses and individuals.
RBI’s forex interventions: Selling dollars to stabilize the rupee reduces rupee liquidity.
Tax Outflows: Increased quarterly tax payments drain liquidity as government cash balances rise with the RBI.
Government Borrowing: Large-scale borrowing absorbs significant liquidity, limiting available funds for banks.
Slow Deposit Growth: Deposit growth lags behind credit demand, tightening liquidity.
External Economic Factors: Global interest rate hikes and capital outflows add pressure on domestic liquidity.

Impacts of a liquidity deficit

Higher interest rates: When there’s less money available in the system, banks tend to raise interest rates on loans to compensate for the scarcity, impacting borrowing costs for businesses and individuals.
Reduced credit availability: Banks may tighten lending, making it harder to access credit, slowing down investment and spending.
Increased cost of borrowing: As the demand for funds exceeds supply, the cost of borrowing money in the money market rises, impacting the rates on treasury bills and other short-term instruments.
Slowdown in economic growth: Reduced credit availability can hinder investment and economic growth, as businesses may struggle to access necessary funds for expansion.
Market volatility: A liquidity deficit can lead to increased volatility in the financial markets as investors scramble to secure funds, impacting stock prices and other asset classes.
Impact on developmental projects: Government initiatives and infrastructure projects may face delays or funding constraints due to limited credit availability.

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Significance of RBI’s Measures

Short-term Relief: Addresses immediate liquidity shortages in the banking system.
Stability: Prevents spikes in short-term interest rates and supports economic activity.
Market Confidence: Ensures banks have sufficient funds to meet credit demands.
Currency Stability: Currency swaps help manage forex reserves and stabilize the rupee.

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