RBI’s double-barreled liquidity surge in May to force down lending rates

Mumbai: The Reserve Bank of India’s “unprecedented” shopping spree is expected to flood the banking system with surplus liquidity, which would not only allow it extra room to accelerate its monetary policy changes but also force lenders to lower their rates.

RBI’s plan to buy additional bonds worth ₹1.25 trillion and its upcoming ₹1.5 trillion dividend transfer to the Union government—both in May—are expected to double the surplus liquidity in the system to ₹5 trillion by the end of June, according to market participants.

Liquidity in the domestic banking system touched a surplus of ₹2.36 trillion on 28 April, RBI data show. An additional surplus would compel banks to lower lending rates at a time when credit growth is expected to slow due to challenges in mobilising deposits and rising stress in unsecured retail and small business loans, the market participants said.

Economists have termed RBI’s bond purchases this year— ₹5.3 trillion year-to-date—as unprecedented. Overall, RBI has infused ₹7.4 trillion in the banking system using tools such as open market operations (OMO), cash reserve rate (CRR) cut, and dollar-rupee swaps since December.

Open market operations involve buying or selling government securities to influence the money available to banks. Cash reserve ratio is the percentage of a bank’s deposits required to be kept with the central bank.

“RBI is being proactive by announcing the OMO as they are anticipating the outflows, which will happen in the system over the next one month or so,” said a treasury dealer at a private bank, requesting anonymity.

“All banks have told (RBI) that only if they keep liquidity in surplus will (banks) be able to pass on the rate cut, otherwise the margins will get impacted. RBI has taken that feedback and decided to keep liquidity in surplus so that banks can pass on the rate cut,” this person said.

Samiran Chakraborty, chief economist at Citibank, in a report on Monday said RBI’s latest OMO purchases were the largest “in such a short span of time”.

“The only other time RBI has done more than ₹5 trillion OMOs was in the post-Covid period. But even then, it took six quarters for RBI to buy more than ₹5 trillion government bonds during covid,” Chakraborty wrote.

Also read | Mint Explainer: What RBI’s new liquidity coverage ratio norms mean for banks

RBI’s policy shift

With RBI’s latest OMO purchases, economists expect the cost of overnight interbank funds to fall further, effectively acting as a rate cut. The weighted average overnight call money rate fell past the repo rate of 6% to 5.87% on Tuesday and is expected to drop further to 5.75%.

RBI aims to anchor the overnight call rate—the inter-bank lending rate for short-term funds—around the repo rate, which is the interest the regulator charges commercial banks. Lower the repo rate, the lower interest banks can charge their customers, which, in turn, could spur economic activity.

Typically, RBI buys bonds through an open market operation when the average call rate is higher than the repo rate or if the 3-month certificate of deposit (CD) spread is higher.

Following RBI’s rate cuts by 25 basis points each in February and April, banks cut their repo-linked lending rates by 50 basis points, but have seen only a 20 basis point cut in retail deposit rates. Wholesale deposits in the form of certificate of deposits, on the other hand, have dropped by 70-80 basis points, according to bankers.

The surplus liquidity will, therefore, help banks to reprice their retail liabilities faster and help bring down the marginal cost of lending rate (most loans to retail and small businesses are linked to MCLR), they said.

Also read | More than a rate cut: RBI’s decision reinforces its dual mandate

RBI’s latest bond purchases at a time when the banking system is already at surplus liquidity suggests a shift in policy.

“While the initial phase of liquidity infusion over Dec-Mar FY25 was to counter the liquidity drain from RBI’s FX (foreign exchange) interventions and seasonal outflow of cash from the banking system, the recent action over Apr-May FY26 indicates a shift in policy objective towards alignment of liquidity conditions with the monetary policy stance,” QuantEco Research said in a report on 29 April.

RBI’s monetary policy committee in April changed its policy stance to “accommodative” from “neutral”, signalling that it was geared towards stimulating the economy through softer interest rates.

“RBI’s intent of maintaining surplus durable liquidity would provide banks a more comfortable environment to further improve supply of credit,” Citibank’s Chakraborty said in his report. “More than ₹5 trillion OMOs would make an already favorable bond demand-supply position even more comfortable, potentially allowing for 10-year bond yields to move below 6.3% for now.”

Also read | ICICI Bank sees RBI repo rate cuts impacting margins

RBI’s forex challenge

Separately, RBI is faced with the challenge of unwinding forward dollar positions over the next few months. At the end of February, RBI’s forward dollar sales position had ballooned to $88 billion, with nearly $30 billion expected to come for maturity in April-May.

The central bank had built up a large dollar sales position in the offshore derivatives market over the last two years to control exchange rate movements.

“RBI is in the process of running down the forward book. As the short dollar forwards come up for maturity, you will have to deliver those dollars to the market,” said the unnamed treasury dealer cited earlier.

“If you deliver the dollars to the market, you will take out higher liquidity. So RBI is reducing the balance sheet on the forex side and increasing the balance sheet on the rupee side,” the dealer added.