In today’s Finshots, we tell you about India’s liquidity crunch and the RBI’s efforts to fix it.

The Story

It’s a workday morning. You walk into a bank to withdraw cash, but find out it’s struggling to meet a big withdrawal. Or maybe you’re a business trying to secure a loan, only to find that funds are tight and borrowing is expensive. These are telltale signs of a liquidity crunch, where readily available money in the financial system dries up. And India is facing one of its worst liquidity crunches in over a decade.

For context, liquidity is the lifeblood of banks. It allows them to lend loans, process transactions and ensure that customers get money when they need it. And banks manage liquidity in four ways:

1. They set aside a portion of the deposits they receive in cash as a buffer, just in case people suddenly withdraw a lot of cash
2. They park some money in accessible funds such as investments in government securities, which they can quickly convert to cash
3. If they don’t have enough money despite the first two steps, they borrow from one another in the interbank market at the repo rate (the commercial lending rate set by the RBI)
4. And finally, if there’s not enough money in the interbank market either, banks borrow from the RBI through something called the MSF (Marginal Standing Facility) at a rate slightly higher than the repo rate

So it’s a given that when these reserves or liquidity shrinks, banks limit lending and hike interest rates to attract deposits. This makes borrowing harder, and naturally you’ll see uncertainty spreading through the economy.

Right now, the daily liquidity deficit in the interbank market has ballooned from ₹1 lakh crore in the early days of January to over ₹3 lakh crores – the worst since 2010!

But it’s not like someone set a gigantic pile of cash on fire overnight. So how did it come to this?

For starters, the RBI’s intervention in the foreign exchange market. You see, whenever the rupee fluctuates too much, the RBI steps in to stabilise it by buying or selling US dollars it has in forex reserves. And to prevent the rupee from crashing, the RBI has been selling US dollars, bringing its forex reserves down from $700 billion in October to $623 billion by mid-January. While this helped prevent a sharp rupee depreciation, it also sucked out a huge amount of rupee out of the market, making liquidity scarcer.

Then there’s the government’s new “just-in-time” payments system which has changed how the government funds the states. Earlier, it sent money in advance, keeping cash flowing in the banking system and the economy. But now, it only releases funds when needed, meaning a lot of cash sits unused in government accounts. And this has left banks short on liquidity.

That’s not all. The recent HDFC - HDFC Bank merger has meant that with HDFC’s old loans maturing, the newly merged bank has had to aggressively raise deposits to keep the lending momentum going. And this has intensified competition among banks to access funds. More Indians are also moving their savings from fixed deposits to mutual funds, further drying up bank deposits. And the explosion of digital payments like UPI and RTGS has made liquidity demands more unpredictable than ever.

To make matters worse, the RBI has been tightening liquidity to fight inflation. It has required banks to keep more money locked in reserves by raising something called the liquidity coverage ratio (LCR). This means locking up around ₹4 lakh crores in government bonds that banks might otherwise have used for lending.

So you can imagine that all of these factors put together are squeezing liquidity from every angle. 

And that explains why overall liquidity, including government cash balances, has plummeted from a ₹3-4 lakh crores surplus in the past two years to just ₹64,350 crores by late December 2024.

So how does anyone fix a situation like this?

Well, the RBI is rolling out a few measures to push liquidity back into the system.

It cut the cash reserve ratio (CRR) from 4.5% to 4%, so that banks have more cash to lend. CRR is the minimum % of a bank’s deposits that it must hold with the RBI. For instance, if a bank received ₹100 in deposits, they could lend only ₹95.50 and had to keep the rest with the RBI. But lowering this has released ₹1.13 lakh crores into the banking system.

Then it ramped up something called daily repo operations by increasing short-term lending to banks from ₹50,000 crores to ₹2 lakh crores in a matter of weeks. And announced to buy ₹60,000 crores worth of government bonds to pump money into the system. And voila! That helps increase liquidity. This is part of something called open market operations (OMO).

Plus, it rolled out a special 56-day loan program (something called a variable rate repo auction) to help banks manage their cash flow for a longer period. Perhaps most notably, the RBI is conducting a $5 billion dollar-rupee swap auction, which allows banks to temporarily trade their dollars for rupees with the RBI.

Now these steps will inject ₹1.5 lakh crores into the banking system, but will they fix the problem?

Maybe not. Because if you remember what we told you earlier, the liquidity crunch has ballooned to over ₹3 lakh crores in just a few days. And that still leaves a massive gap waiting to be filled.

So some argue that the RBI will need to cut CRR further or tweak liquidity rules to free more money. Others believe these moves hint at a coming interest rate cut, possibly by 0.25% in February and up to 1% by the end of 2025.

But the bigger question is: Does India need a complete rethink of its liquidity management strategy?

The flexible inflation-targeting framework, introduced in 2014 under the Urjit Patel Committee, was designed to bring inflation down to 4% in phases. And so far, it’s done a pretty good job. But as the economy evolves, maybe it’s time to ask if this needs to become more dynamic and adaptable now. After all, managing liquidity isn’t just about keeping inflation in check, it’s also about ensuring the financial system can adapt to modern liquidity shocks.

And it isn’t just a banking issue. When liquidity is scarce, homebuyers struggle to get loans, and it also affects financial markets. Traders face credit constraints and it further fuels market volatility. Investors, especially in debt markets, demand higher returns due to rising borrowing costs, leading to bond yield spikes. Case in point: Indian government bond yields hit 6.85% in January, the highest since November 2022. And companies big and small see a hit on their bottom line, impacting overall market sentiment.

The catch though is that too much liquidity can trigger inflation and asset bubbles.

And that’s why striking the right balance right can be tough for the RBI.

With digital payments running 24/7, banks can’t rely on old-school liquidity buffers. They need smarter tools. Say quicker forex swaps, long-term lending options with the RBI, or even linking the cash they must hold (CRR) with their broader liquidity needs (LCR) to ensure that they’re not left scrambling for funds. Maybe even adjust liquidity rules based on regional and sectoral needs?

Given how foreign funds have a substantial say in domestic liquidity, maybe India needs a strategic liquidity reserve as a buffer to handle big fund outflows without burning through forex reserves?

With savings shifting from fixed deposits to market-linked investments, banks could rethink their deposit strategies. The RBI could push banks to prepare for liquidity cycles rather than reacting when a crisis hits. And the government and RBI could work together to unlock idle cash currently stuck in government accounts, easing liquidity pressures sustainably.

So yeah, that’s the long and short of what’s up with India’s liquidity crunch.

Until next time…

Don’t forget to share this story on WhatsApp, LinkedIn and X.

📢Finshots has a new WhatsApp Channel! If you want the sharpest analysis of all financial news without the jargon, Finshots is the place to be! Click here to join.

Only 17% of millennials have a term plan❗

Here’s why getting a term plan early can do wonders for you & your family:

✅Protection: Simply put, term insurance is where you pay a small amount of money in exchange for a large amount of protection. This protection usually kicks in in the event the policyholder passes away.

But not just that, if you ever develop a critical illness (eg. cancer) and have to quit your job, a term plan can give you a lump sum amount to make up for the lost income.

✅Secure Your Parents: As your parents near retirement, they may start to rely on your income. And so, a term plan will give you peace knowing that they'll be financially supported even in your absence.

✅Low Premiums Forever: A term plan of ₹1 crore will cost you much lower premiums at 25 years than at 35. You can even get a ₹1 crore cover for as little as ₹10,000 a year if you are young and healthy. Plus, once these premiums are locked in, they remain the same throughout the term!

So don’t delay it! As they say, “The best time to buy term insurance was yesterday; the next best time is today.”

Click here to book a FREE call with Ditto Insurance’s certified advisors and get your personalised term insurance guidance.