Even as growth is stuttering, partly due to elevated interest rates and RBI’s macroprudential measures, tight liquidity conditions threaten to make matters worse. System liquidity has tightened considerably over the past month with average daily liquidity deficit at ₹1.55 lakh crore between December 16, 2024, to January 16, 2025, compared with average daily surplus of around ₹62,000 crore in the preceding 30 days.

The central bank has conducted 18 variable rate repo operations in the past month to address the deficit, injecting ₹12.55 lakh crore of short-term liquidity into the banking system. The tight liquidity conditions are impacting overnight rates with MIBOR (Mumbai Interbank Offered Rate) spiking to 7 per cent and weighted average call rate moving to 6.88 per cent in the second week of January; above the upper band of the LAF corridor, at 6.75 per cent. In a bid to address the disruptions to short-term rates, the RBI has fallen back on VRR auctions. This may not be enough.

The primary reason for the liquidity tightness — intervention in the forex market by RBI to stem rupee depreciation — is likely to persist for some time. The rupee has depreciated around 3.6 per cent against the dollar since October 2024 due to the rally in the dollar and rising yields of US treasury securities on optimism regarding Trump’s policies helping the US. RBI had to intervene in both the spot and forward markets in recent months, selling dollars to support the rupee. This has drained system liquidity. According to Nomura, RBI’s forex market intervention has drained ₹3.8 lakh crore from the system in the last quarter of 2024. The rupee will continue to face downward pressure in the coming days as Trump’s tariffs and other protectionist policies may strengthen the dollar further. Besides forex intervention, the busy season in the last quarter of the fiscal year will also tighten liquidity. RBI will have to deploy all tools in its arsenal to tackle this situation. Else, market rates will spike further, hurting growth.

Use of USD-INR buy/sell swap is an option to increase supply of rupee, wherein the central bank sells rupee in spot market and takes the opposite position in the forward market. These swaps are typically for a two-to-three year duration. The central bank may also have to conduct open market operations in the coming months. The VRR auctions can be held for securities with slightly longer maturity, say 28 or 56 days. With the impact of the CRR cut in December policy already mitigated by subsequent events, another CRR cut can be considered. Stabilising the rupee will also help indirectly. India needs to enter into more agreements with trading partners for settlement of bilateral trade in rupees, akin to the pact with United Arab Emirates, Indonesia and Maldives. The central bank can also take other measures to support the rupee, such as relaxing norms for external commercial borrowings and easing FDI norms in some sectors.