RBI prepares for Trump tariff fallout with liquidity moves

Donald Trump’s return to reciprocal tariffs has grabbed the headlines. But as attention remains fixated on trade spats, a quieter development is unfolding in India with far-reaching implications: the Reserve Bank of India’s (RBI) April monetary policy meeting.

With the global outlook darkening, monetary policy is no longer a six-times-a-year affair. It’s an active, continuous process. As India enters FY26, the RBI faces three urgent imperatives: ensure systemic liquidity, facilitate monetary transmission, and guard against downside risks to stability. All this while preparing the financial system for the tremors set off by the US administration.

Managing liquidity

Liquidity in the banking system turned surplus in later March 2025, after nearly four months of persistent deficit. This deficit is worth dissecting, because it could well return.

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Money comes into our economy through two ways: RBI (by buying dollars or bonds) and commercial banks (by lending or investing in securities).

Post-Covid, RBI’s share in money creation surged as it eased monetary policy, but by December 2024, its contribution had fallen to multi-year lows. This was partly because the overall money stock rose—driven by lower government spending between April and July 2024, and a foreign investor sell-off from October onwards—and partly because the RBI’s contribution to money creation dipped, as it began selling dollars to support the rupee. A tighter policy stance further squeezed liquidity.

A more nuanced picture emerges when we look at the sources of incremental money supply.

In 2022-23, robust growth in bank credit and steady government spending made up for RBI’s foreign exchange intervention. In 2023-24, all drivers held steady. But by October 2024, there was a double whammy: bank credit was slowing, and RBI’s dollar sales also sucked out rupee liquidity. Both channels of money creation were blocked. The resulting liquidity squeeze forced the RBI to pump in liquidity via a cut in the cash reserve ratio, rupee-dollar swaps and open market operations.

With global uncertainties looming, more episodes of dollar outflows and currency volatility are likely. That is why RBI’s actions to bring the system out of deficit mode and its assurance of maintaining orderly liquidity are both valuable.

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Indeed, recent media reports suggest that RBI may provide on-tap fixed-rate liquidity to banks: this would go a long way towards keeping credit channels open.

Monetary transmission

Ample liquidity is a precondition for lower interest rates to filter through the economy. Tight systemic liquidity restricts bank lending because there is a high “cost of liquidity”, which in turn keeps lending rates elevated.

Case in point: Though the RBI cut repo rate by 25 basis points (bps) in February, the average cost of a one-year certificate of deposit (CD) remained at 7.5-7.7%, 125 bps over the repo rate (a fact highlighted by economist Neelkanth Mishra at various forums).

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Senior banker Uday Kotak recently pointed out that the marginal cost of deposits for leading banks was as high as 9% because many were taking CDs at 8%. To get banks to lend more and at lower rates, at the very least, liquidity will need to be sustained at comfortable levels.

The silver lining: the system is structurally better positioned for transmission today.

As of December 2024, about 60% of all floating-rate loans of scheduled commercial banks were linked to an external benchmark in December 2024. This allows faster pass-through of rate cuts, as compared to the 2015-2018 easing cycle, when loans were linked to the internally-set, more opaque, marginal cost of funds.

Further, bank balance sheets have never been healthier.

Unlike the 2012-2013 easing cycle, when rising non-performing loans made banks averse to lending, this time, RBI has taken prompt action to manage risk taking in unsecured lending and micro finance loans.

Growth and stability

The latest tariff announcement poses a downside risk to growth and market stability. The government and RBI will have to play their parts to safeguard the economy.

While the government is already exploring a bilateral trade agreement with Washington, fiscal constraints mean it has limited room for direct stimulus. That means the RBI will have to step up to support growth via accommodative monetary policy.

Central banks around the world are tweaking their policies to combat trade and growth uncertainties.

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Some have opted for a rate pause, choosing to wait and watch for more clarity (Australia, Japan, England, Indonesia, Malaysia); others have signalled a rate cut in the near future (Europe, Singapore). In contrast, China has gone all out to fire domestic growth through monetary easing, and there are whispers of a yuan devaluation.

India is likely to take a middle path: keep liquidity easy and pace rate cuts over the year depending on how the tariff situation evolves. A rate cut is widely expected, which along with continued assurance of liquidity, will do much to restore confidence.

The author is an independent writer in economics and finance.