The Reserve Bank of India (RBI) has called a bankers’ meeting this week to discuss its liquidity management framework. The subject of discussion — just a week before the RBI’s first bi-monthly monetary policy for 2025-26 (FY26) — has sparked intense speculation in the market. Bond dealers and treasury managers are wondering whether the central bank is considering new instruments to manage liquidity.
Last week’s Banker’s Trust column (“The liquidity conundrum”) dealt with the issue in detail – exploring the instruments at the RBI’s disposal and their usage. Let’s take a deeper dive.
On the coffee table, we’ve been discussing the pros and cons of deficit versus surplus liquidity. And, how much surplus is ideal — “appropriate,” “adequate,” or “abundant”?
An entity’s liquidity needs differ from those of the market and the financial system. Stripped of jargon, the system should have enough liquidity to keep the overnight call money rate close to the policy repo rate.
Repos, or repurchase agreements, are contracts for the sale and repurchase of government securities and short-term treasury bills. In other words, a repo is a short-term, interest-bearing loan backed by government securities. Banks borrow money from the RBI through this window to meet short-term needs, not to build loan books. Their other option is borrowing from the overnight call money market.
While the repo window serves as a monetary stabilisation mechanism that the RBI uses as a daily liquidity management tool, the repo rate is an interest rate signal.
The development of the repo market is closely linked to that of the overnight call money market as a pure interbank market. In its October 1998 monetary policy, the RBI had announced that the call/notice/term money market would be purely an interbank market with additional access only to the primary dealers who buy and sell government securities.
The evolution of repo as a liquidity management tool is the result of a fundamental shift in the RBI’s monetary policy with the introduction of the liquidity adjustment facility (LAF) in June 2000. This marked a transition from direct monetary control instruments to indirect, market-based mechanisms. Until a few years ago, LAF operations were conducted through repo/reverse repo transactions.
As a prelude, an interim liquidity adjustment facility (ILAF) was introduced in April 1999. Subsequently, the RBI’s April 2000 monetary policy statement announced the LAF through a system of repo and reverse repo auctions.
Although the RBI does not formally target overnight interest rates, the LAF operated through daily repo and reverse repo auctions, establishing a corridor for short-term rates in alignment with policy objectives. Banks could borrow from the RBI at the repo rate to meet short-term needs and park excess funds with the regulator at the reverse repo rate, which was set lower than the repo rate. For the overnight call money rate, the reverse repo rate served as the floor and the repo rate as the ceiling.
Internationally, ‘repo’ refers to liquidity injection by the central bank against eligible collateral securities, while ‘reverse repo’ refers to liquidity absorption by it against eligible collateral. In India, however, in early days, ‘repo’ signified liquidity absorption and ‘reverse repo’ denoted liquidity injection. The RBI aligned its terminology with global practices in November 2004.
Before this shift, in the 1990s, after the economic liberalisation, the bank rate was used to signal RBI’s policy stance alongside other instruments. Though still in place, it has lost relevance.
The RBI has not formally abolished the reverse repo rate, but for practical purposes, it is defunct as a tool for absorbing excess liquidity. The fixed reverse repo rate currently stands at 3.35 per cent. Instead of using this rate, the RBI now employs variable rate reverse repo (VRRR) auctions to determine pricing. While the repo rate remains the policy benchmark, the RBI no longer uses the fixed repo rate for liquidity infusion. It has also become variable and, hence, market-determined.
At present, the 6.25 per cent repo rate is the mid-point of the LAF corridor. The marginal standing facility (MSF) at 6.5 per cent serves as the ceiling, while the standing deposit facility (SDF) at 6 per cent acts as the floor.
The MSF, introduced in May 2011, allows banks to borrow overnight at a rate higher than the repo rate, helping them manage short-term liquidity needs during financial stress.
The SDF, launched in April 2022, absorbs excess liquidity by allowing banks to temporarily deposit surplus funds with the RBI and earn interest.
If there is surplus liquidity in the system, call money rates will be below the repo rate (and close to the SDF). If liquidity is scarce, call rates will be above the repo rate (and close to the MSF).
So, how much liquidity should the system have? Ideally, it should be sufficient to keep the overnight call money rate near the repo rate, without exceeding the MSF or dropping below the SDF.
Since January, the RBI has been trying to maintain this balance by infusing liquidity through three different instruments, in addition to keeping the daily repo window open.
First, it introduced the long-term variable repo rate (VRR) auctions of 42, 49 and 56 days, and infused Rs 1.83 trillion to reduce the liquidity deficit. This is a deviation from the practice of conducting short-term VRR auctions between four and 14 days to manage liquidity. All long-term VRR auctions will mature in April.
Besides this, it has conducted open market operations (OMOs) – selling government bonds and infusing liquidity – worth Rs 2.5 trillion since January.
The third instrument of its liquidity infusion operation has been the three-year dollar buy-sale swaps. Through $25 billion in forex swaps, the RBI has injected around Rs 2.15 trillion into the system.
It is likely to continue infusing liquidity through different instruments to ensure that the overnight call money rate is close to the policy rate. That seems to be the objective.
Let’s also look at how the RBI has handled the rupee depreciation. Both are inter-linked because when the RBI sells dollars to meet forex demand, it absorbs rupee liquidity; when it buys, it releases the rupee.
We have come a long way from the Liberalised Exchange Rate Management System (LERMS) introduced in March 1992. LERMS was a dual exchange rate system, where exporters could convert a portion of their foreign exchange earnings at market-determined rates, while the remaining was surrendered to the RBI at a fixed rate. Introducing partial convertibility of the Indian rupee, LERMS was the first step towards a market-determined exchange rate system.
Officially, the RBI does not influence the rupee’s level but intervenes to curb excessive volatility in the market. Unofficially, it does intervene to protect the currency from sharp depreciation. The erosion in foreign exchange reserves, till recently, reflects such actions. The RBI also steps in to counter speculators in the forex market. During the late-1990s East Asian crisis, under Governor Bimal Jalan, the RBI had waged a war against the speculators.
We have seen skirmishes, if not war, in March. When the rupee started depreciating sharply in December, post Donald Trump’s return to the White House, the RBI sold large quantities of dollars.
RBI’s aggressive dollar sale encouraged the speculators to bet on the greenback. At such times, rupee movements are often driven not by fundamentals but by market expectations of what the central bank might do. It was a one-way street for the rupee – traders were going long on the dollar, importers were rushing to hedge, and exporters were avoiding hedging. All expected the dollar to keep getting stronger against the rupee.
All three – traders, importers and exporters – were on one side, while the RBI was on the other, supplying dollars. The players were all taking positions based on what they expected the RBI to do. One fine morning, the RBI changed its strategy, and allowed the rupee to depreciate further — catching the punters off guard. That reversed the trend. No body is talking about rupee depreciating to 90 a dollar at this point. The message to the speculators is clear: The RBI is a variable they shouldn’t attempt to predict.
The author, a Consulting Editor of Business Standard, is a Senior Advisor, Jana Small Finance Bank.
This column first appeared in Business Standard
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