India’s liquidity windfall puts RBI in a fresh policy dilemma: Axis Capital

The Reserve Bank of India (RBI) faces a fresh policy challenge as a rise in system liquidity after its foreign-exchange measures leaves the central bank with the task of absorbing excess funds without disrupting credit growth or financial markets, according to Axis Capital.

The brokerage said the RBI's recent measures have, for now, broken the feedback loop that had reinforced expectations of rupee weakness. The impact is visible in a sharp decline in foreign-exchange volatility and forward premiums across maturities.

While the initial improvement coincided with a decline in Brent crude prices in the second half of June, the gains have persisted even after oil prices recovered, suggesting that the RBI's measures have played a significant role in stabilising market expectations.

Liquidity surge creates new challenge

The RBI's foreign-currency deposit measures have contributed to a substantial increase in system liquidity. Axis Capital estimates that system liquidity has reached around ₹11.3 lakh crore while FCNR flows, which are exempt from the cash reserve ratio (CRR), account for about 4.3% of total deposits. This leaves the RBI with the task of absorbing at least ₹8-9 lakh crore of excess liquidity in the near term.

Currency leakage could eventually absorb around ₹3 lakh crore by March 2027, Axis Capital estimates. However, the impact is expected to be limited in the immediate term, with currency leakage unlikely to exceed ₹1 lakh crore by December 2026. That makes the choice of liquidity-absorption tools critical.

Axis Capital favours open market operation (OMO) sales of government securities maturing over the next one to two years. However, it cautioned that aggressive bond sales could trigger an adverse market reaction, particularly against a challenging global interest-rate backdrop.

A two-way OMO strategy, selling short- and medium-duration securities while signalling a willingness to purchase longer-duration bonds later, could help address concerns around market liquidity and bond yields, the brokerage said.

RBI's FX measures have eased funding pressures

The RBI's measures have also eased funding conditions for banks. Axis Capital noted that certificate of deposit (CD) rates have fallen sharply. This should lower incremental funding costs on outstanding CDs and non-resident term deposits (NRTDs), improving bank profitability while strengthening liquidity coverage ratios and increasing the pool of loanable deposits.

The brokerage expects the RBI's foreign-exchange operations to continue reducing pressure on the rupee without materially increasing the central bank's net foreign-currency exposure.

Axis Capital had estimated in June that the RBI could reduce its net forward short position of around $50 billion over one year, effectively transforming liabilities rather than adding to overall debt. It said that expectation remains unchanged.

The RBI could also selectively use sell-buy swaps with maturities beyond one year, particularly where the central bank could potentially generate a profit. Axis Capital pointed to $15-20 billion of buy-sell swaps conducted in March 2026 as a possible source for such transactions. However, extensive use of this channel could push FX forward premiums higher. The brokerage therefore expects the RBI to use it selectively.

Other tools could help absorb excess liquidity

Axis Capital said the RBI has several short-term instruments available to manage the liquidity surplus. These include variable rate reverse repos (VRRR), cash management bills (CMBs), strong advance-tax collections expected in September and adjustments to the government's borrowing calendar.

These measures could allow the RBI to absorb liquidity without immediately resorting to a sharp increase in the CRR.

A 1 percentage point increase in the CRR could take the ratio to 4% but would absorb only around ₹2.5 lakh crore of liquidity, according to Axis Capital. The current CRR stands at 3%. With around 5% of deposits now exempt from CRR requirements, the effective system-wide impact has already fallen by about 15 basis points.

Axis Capital estimates that the RBI could instead raise the CRR on the remaining deposits by around 25 basis points, taking the ratio to 3.25%.

However, the brokerage warned that a larger CRR increase could weigh on credit growth and economic activity. A 1 percentage point hike would be particularly significant, given that the CRR has remained below 4% only during the Covid period in the past five decades.

The timing could also be critical. Axis Capital does not expect a CRR increase before the December meeting of the Monetary Policy Committee, given that September-November is typically a peak period for credit demand.