RBI - The Sentinel of Stability

As the RBI turns 90, a look at how it has managed liquidity through thick and thin.

The Reserve Bank of India (RBI) has been the cornerstone of India's financial system since its establishment in 1935, maintaining stability through adept management of liquidity and, thereby, helping the country navigate the complexities of a rapidly evolving economic landscape.

This article seeks to elucidate the various tools employed by the RBI to regulate liquidity in the Indian economy, tracing their application in response to pivotal economic events.

The Importance of Liquidity Management

Liquidity is the lifeline of an economy. A smooth and calibrated flow of money ensures enough lending capacity, thus boosting credit. It also helps anchor interest rates, driving consumption.

Liquidity management refers to mechanisms employed to ensure that the money in an economy is adequate to support growth without triggering inflation or financial instability.

RBI's Liquidity Management Toolkit

The central bank uses various tools and frameworks to manage liquidity, including:

• Setting the tone for the overall interest rate structure in the economy via the repo rate

• Absorbing excess liquidity from the system through the reverse repo rate mechanism

• Requiring commercial banks to hold a proportion of their deposits as cash reserves with the RBI, based on the cash reserve ratio (CRR)

• Mandating banks to hold a proportion of their deposits in cash, gold and other securities by stipulating the statutory liquidity ratio (SLR)

• Purchasing or selling government securities (G-secs) through open market operations (OMOs) to influence money supply

• When there is surplus liquidity, often due to large foreign exchange inflows, the RBI issues government securities, by conducting auctions, under the Market Stabilisation Scheme (MSS) to absorb excess liquidity.

• Providing liquidity to commercial banks via the liquidity adjustment facility (LAF) platform

• Allowing banks to deposit excess funds with the RBI at a fixed rate based on the standing deposit facility (SDF)

• Buying long-term G-secs and selling short-term G-secs through Operation Twist to reduce long-term interest rates

• Employing a market-driven flexible tool, variable rate reverse repo, that allows the absorption of excess liquidity from the system through auctions, where banks bid at variable interest rates for placing short-term deposits with the RBI

• Being the last borrowing option for banks facing unexpected liquidity shortages through its marginal standing facility (MSF); this allows banks to borrow from the RBI on an overnight basis at a penal rate

The RBI follows a corridor liquidity management system, with the MSF as a ceiling, SDF as the floor and the policy repo rate in the middle. The ideal situation is one where call rates move within this corridor, which the central bank ensures through its LAF.

The RBI also intervenes in the foreign exchange market to influence the exchange rate and manage liquidity via currency market intervention, by buying dollars to prevent the rupee from appreciating, or selling dollars to prevent the rupee from depreciating.

In addition to these tools, the RBI uses measures such as long-term repo operations, which provides liquidity to banks for a longer tenure, aimed at specific sectors of the economy.

Priority sector lending (PSL) is an important diktat of the RBI to banks to provide a specified portion of their lending to specific sectors, such as agriculture and allied activities, micro and small enterprises, poor individuals for housing, students for education, other low-income groups and weaker sections. The RBI incentivises the banks having surplus in their PSL to ‘sell’ the surplus to peers that are falling short.

By leveraging these tools and measures, the RBI is able to effectively manage liquidity and maintain financial stability in the economy.

Key RBI Actions Over the Years

The RBI’s liquidity management framework has evolved over the years, on account of changing economic conditions and crisis. As the Indian economy continues to grow and integrate with the global financial system, effective liquidity management will remain crucial for maintaining financial stability.

Global Financial Crisis

The Global Financial Crisis of 2008-2009, one of the worst since the 1929 Great Depression, had limited initial impact on India's financial sector, owing to the country’s low exposure to risky assets and foreign banks.

However, as the crisis deepened, India felt the effects of reduced foreign equity flows, tightened credit markets and decreased global trade, pressurising domestic credit and liquidity.

The RBI responded to this by using various instruments to manage liquidity, ensuring adequate funds in the system from mid-September 2008.

Some of these measures were[1]:

[1] https://www.indiabudget.gov.in/budget_archive/es2008-09/chapt2009/chap46.pdf

The prompt and proactive steps by the RBI ensured adequate liquidity and stabilised interest and inflation rates, which helped regain investor confidence and restore the economic growth momentum The consequences of the RBI's inaction would have been severe, potentially leading to a deeper and more prolonged economic downturn which is explained as follows:-

-Liquidity Crunch & Credit Freeze

Without RBI’s active liquidity support, Indian Corporates would have struggled to get working capital which could have adversely impacted business and finance.

-Sharper GDP Contraction

An adverse impact on business and finance would have hit India’s exports, IT services, and manufacturing leading to a sharper contraction in the growth of the Indian economy.

-Weakening of the rupee

Without RBI’s intervention, the rupee would have weakened against the greenback. Imports would have become costlier leading to the widening of the current account deficit and trade deficit. Since India imports more than 80% of the oil requirements, oil prices would have become costlier. Higher crude oil prices would have resulted in an increase in domestic inflationary pressures.

-Rise in Unemployment

Without liquidity support and inflation on the rise, there would have been an increase in layoffs resulting in increased unemployment.

-Banking Sector stress

Increased unemployment would have lead to loss of income which could have resulted in an increase in non-performing assets that could have snowballed into a systemic banking crisis.

Demonetisation in 2016

The withdrawal of the legal tender status of Rs 500 and Rs 1,000 denomination currency notes, announced on November 8, 2016, led to a large structural liquidity surplus, which impacted the banking system. The RBI took several steps to absorb this excess liquidity on review of the liquidity condition. The RBI absorbed the surplus liquidity via a mix of conventional and unconventional instruments to ensure the money market rates remain aligned to the repo rate.

[2]&2 https://www.rbi.org.in/Commonperson/english/scripts/PressReleases.aspx?Id=2029

[4]&7 https://www.indiabudget.gov.in/budget2017-2018/es2016-17/echap03_vol2.pdf

[6]https://static.investindia.gov.in/s3fs-public/2020 07/Liquidity%20Management%20in%20the%20Time%20of%20Covid-19%20An%20Outcomes%20Report.PDF

To be sure, major central banks such as the US Federal Reserve (Fed) and the European Central Bank (ECB) implemented stimulus packages to overcome the pandemic-induced downturn. Key policy rates were cut to historic lows and liquidity measures were introduced to prevent credit crunch. The US Fed scaled up OMOs, while the ECB provided additional bridge financing and eased the conditions for targeted refinancing operations. These measures, combined with large fiscal support programmes, improved the financing conditions, leading to signs of recovery.

While many developed countries introduced fiscal stimulus packages, considering India had limited fiscal space, constrained by its fiscal deficit of close to 10% of GDP in the pre-pandemic period, no sizeable fiscal stimulus were announced by the Indian government as it was more targeted towards disadvantaged group rather than a large scale fiscal boost. However, the RBI's conventional and unconventional measures, on their part, helped the domestic financial market regain normalcy, with increasing turnover, narrowed spreads and growing investor confidence, though credit growth remained a concern, clouding the outlook.

The RBI’s liquidity guidance  dispelled illiquidity fears and bolstered financial market sentiment. Convinced by its communication and actions, market participants also responded synchronously and cooperatively.

Measures such as policy rate cuts, proactive liquidity management and regulatory forbearance against the backdrop of global spillovers and the nation-wide lockdown ensured smooth transmission of policy rate cuts across the market spectrum, narrowing of risk spreads and a rekindling of the corporate bond market.

In the G-sec market, in which risk-free benchmarks evolve, a record low weighted average cost of 5.78% and an elongated weighted average maturity of 14.9 years testify to the credibility of the Indian central bank’s monetary and liquidity management operations.

Without the RBI's liquidity measures, the financial system would have faced a severe liquidity crunch, leading to a sharp increase in borrowing costs and making it difficult for businesses and individuals to access credit. The lack of monetary policy easing and liquidity measures would have led to a sharper contraction in economic growth, potentially exceeding the 7.3% decline in GDP growth in FY21, and a longer and more severe recession. The absence of regulatory forbearance and special refinancing facilities would have led to a loss of confidence in the financial system, potentially triggering a bank run or a credit crisis, and a sharp decline in asset prices. and the lack of support for NBFCs and MFIs would have reduced access to credit for small businesses, farmers, and low-income households.

August Market Update

The MPC acknowledges inflation outlook turned more benign than expected, given the sharp slide since the previous meeting. In June, CPI inflation stood at 2.1%, close to the lower end of the MPC’s target range of 2-6%, mainly due to a fall in food inflation (-0.2% in June). However, core inflation (i.e., inflation excluding food and fuel) was higher (4.4%).

Food inflation settled at -1.1%, also the lowest since January 2019, from 1.0% in May, while fuel inflation slipped to 2.6% from 2.8%. Core inflation inched up to 4.4% in June from 4.2% in May, driven by a broad-based uptick across various subcategories, including surging gold inflation, but remained below its decadal trend rate of 4.9%.

Yet the MPC expects CPI inflation to rise in the second half of this fiscal. This is because the favourable base effect that had kept food inflation down so far will wane and domestic demand will rise due to lower interest rates and the upcoming festive season. The MPC expects inflation to cross its 4% target from the fourth quarter. It projects CPI inflation to rise from 2.1% in second quarter to 3.1% in the third and to 4.4% in the fourth quarter. It expects the gauge to rise further to 4.9% in the first quarter of next fiscal.

The RBI Governor assured that liquidity conditions will remain conducive for transmission of past rate cuts to broader market interest rates. Systemic liquidity has been in surplus since the start of this fiscal until July. A 100- bps cut in cash reserve ratio (CRR) between September and December 2025 will further help maintain adequate liquidity.

The MPC’s announcement was in line with our expectations. The impact of past rate cuts will continue to unfold and believe inflation could see a mild rise in the second half of the fiscal. A prudent policy approach is also required in a volatile global environment and risks of imported inflation via a weaker rupee. India’s GDP should grow by 6.5%, with risks to the downside from tariff hikes by the US. The tariff impact will likely get more pronounced in the second half of this fiscal as the rates get finalised. However, domestic demand will help offset external headwinds. RBI’s rate cuts of this fiscal will be pivotal in improving domestic demand, especially in urban areas.

Note: Till August 6, 2025

Source: Bank of International Settlements, Crisil

https://www.rbi.org.in/commonman/English/Scripts/PressReleases.aspx?Id=3265

Given the uncertainties, major central banks remain cautious in easing rates. The US Federal Reserve (Fed) has not cut the policy rate in 2025 so far. S&P Global expects a 50 bps cut by the Fed towards the end of 2025, possibly starting in September if the labour market weakens. We expect one more repo rate cut by the MPC this fiscal. The trajectory of inflation, the impact on growth from higher US tariffs and weaker global trade will bear watching in this regard.

Over the years, the RBI has demonstrated its commitment to maintaining price stability, promoting economic growth, and ensuring financial stability. As the Indian economy continues to evolve, the RBI's prudent policy decisions, including the recent rate cuts, have provided a significant impetus to growth, particularly in the face of global headwinds. As we look to the future, the RBI's continued vigilance and proactive approach will be crucial in steering the Indian economy towards its growth potential, and we are confident that the institution will continue to play a vital role in shaping the country's economic destiny.

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