The RBI recently facilitated a $10 billion dollar-rupee swap with a three-year tenor, set to be settled on March 4, with the reverse leg of this scheduled for March 6, 2028.
This currency swap, an agreement between two parties to trade one currency for another at a preset rate over a given period, is one among many key elements of the RBI’s strategy to manage liquidity and stabilise the rupee.
Stabilisation in the Indian and emerging market context doesn’t necessarily mean a fixed or hard-pegged exchange rate (with respect to, say, the US dollar), but one that is less volatile.
India, under the RBI governorship of Raghuram Rajan and later Urijit Patel, managed a less volatile currency tenure, which was critical in ensuring stable cross-border mobility both in and out of the market. A well-managed depreciation is distinct from a rapid, unchecked depreciation, and the RBI has found it difficult in the last few years to ensure the former.
Despite certain interventions, the value of the rupee continues to depreciate (as against the dollar). The Indian banking system also faced a liquidity deficit of Rs 1.7 lakh crore as of February 20, which points our attention towards a much deeper structural imbalance within the economy.
Forex liquidity, or the availability of money in the financial system, is essential for cross-border economic activity. India has managed a higher buffer in its forex base. Sufficient macro-liquidity in the economy ensures businesses can access credit, which in return boosts expansion and creates jobs. However, a liquidity crunch, on the other hand, raises borrowing and lending costs, slowing growth and dampening consumer confidence.
To counteract the liquidity deficit, the RBI has already infused liquidity through multiple measures, including Rs 1.4 lakh crore worth of bond purchases and a $5 billion dollar-rupee swap – these also have an inflationary spiralling effect in the short term, which can drive the prices of goods and services up.
Banks maintain liquidity through a structured process. First, they set aside a portion of the deposits they receive in cash as a buffer to manage sudden withdrawals. Next, they invest some money in accessible funds such as government securities, which can be quickly converted to cash. If these measures prove insufficient, banks then turn to the inter-bank market, borrowing at the repo rate set by the RBI.
As a last resort, if the inter-bank market itself faces a liquidity crunch, banks borrow directly from the RBI through the marginal standing facility at a rate slightly higher than the repo rate. When reserves shrink significantly, banks limit lending and hike interest rates to attract deposits, tightening credit availability across the economy.
The daily liquidity deficit in the inter-bank market ballooned from Rs 1 lakh crore in the early days of January to over Rs 3 lakh crore at the end of that month, which was the worst in over a decade, as per some reports. This stark liquidity shortfall raises critical questions about the RBI’s approach to monetary policy and its effectiveness in stabilising the financial system.
But a critical question arises for one to analyse: How did this situation deteriorate?
We explore this by examining the RBI’s historical trends.
The RBI’s decision to abandon a flexible exchange rate and adopt a de facto peg to the dollar in 2022 has had severe and probably unintended consequences.
While the initial rationale might have been to stabilise the economy, its own actions – done in a longer, more aggressive form – has ended up making the rupee’s situation worse. Instead of allowing the rupee to fluctuate naturally, the RBI intervened repeatedly, leading to several cascading effects that hurt the broader economy in multiple ways.
One of the biggest problems with this approach was the way it encouraged excessive external commercial borrowing. Indian firms may have taken advantage of the stable exchange rate to borrow more from international markets, believing that their repayment burden would remain predictable.
As a result, external commercial borrowings surged to nearly $190.4 billion by September 2024. However, this created a dangerous dependency on foreign debt. A pegged exchange rate might seem like a safeguard in the short run, but it actually puts the entire system at risk because it artificially suppresses the volatile nature of currency instead of addressing the underlying economic challenges.
Also read: RBI Is Buffering Against Impending Volatility, Rate Easing Can Wait
Arvind Subramanian in a recent column pointed out that the RBI’s reluctance to allow the rupee to depreciate was not just any other policy mistake but a major risk to financial stability altogether. By spending foreign exchange reserves to defend the rupee, the central bank ended up weakening India’s ability to respond to future economic shocks.
Foreign exchange reserves fell to a ten-month low to $625.87 billion in January. This depletion meant that when global financial conditions tightened, India was left with fewer resources to manage capital outflows. In simpler terms, the RBI chose to burn through its reserves in an attempt to maintain an illusion of stability, only to find itself in an even weaker position when external pressures mounted.
The possibility is that the RBI’s policy choices may have ended up benefiting a select group of large borrowers while exposing the broader economy to significant risks. Normally, when firms borrow from abroad, they take on the risk that the rupee might depreciate, which can possibly make their repayments more expensive.
Nevertheless, by keeping the rupee unnaturally stable, the RBI effectively removed this risk for those with access to international capital markets. This meant that large corporations and financial elites were shielded from currency depreciation, allowing them to profit from lower interest rates abroad while avoiding the usual risks associated with borrowing in foreign currencies.
Meanwhile, the rest of the economy, including smaller businesses and exporters, suffered from an uncompetitive exchange rate that hurt both growth and employment.
These actions also created severe liquidity constraints in the banking sector, which worsened credit availability in the domestic economy. Public sector banks have seen their credit-deposit ratios rise over time, with the Bank of India reaching 81.97% and the Bank of Maharashtra 81.95% by December 2024.
A rising credit-deposit ratio indicates that banks are lending a greater proportion of their deposits by reducing their liquidity cushion and increasing systemic risk. This problem was exacerbated by the RBI’s own policies, which made borrowing from abroad attractive for large firms but did little to support domestic credit expansion.
Credit-deposit ratio of public sector banks. Chart provided by authors.
Despite the RBI cutting the policy repo rate, lending rates have largely remained elevated due to the liquidity crunch. Banks, facing a shortage of deposits relative to their lending needs, usually struggle to pass on lower rates to businesses and consumers. This creates a counterintuitive situation where monetary policy becomes ineffective in stimulating economic activity.
For actual growth to materialise, it is absolutely essential that the economy has sufficient liquidity – something the RBI’s currency policy ultimately undermined and ignored.
This approach didn’t just stop there. The RBI’s method of managing liquidity has set off a chain reaction across the multiple different sectors of the economy, from businesses to households and financial markets, and it’s imperative to understand that liquidity isn’t just about banks having enough cash.
Consider homebuyers for instance. With liquidity drying up, securing housing loans has become difficult, which results in a further slowing down of the real estate sector, which stands as one of India’s biggest job creators.
Small and medium businesses that rely on short-term credit are finding it more expensive to keep their operations running, and expansion plans are being shelved as crucial investments get delayed. And then there’s the stock market: traders are struggling with tighter credit, which is leading to reduced participation and more volatility.
Investors, especially those in debt markets, are demanding higher returns because borrowing has become costlier. Evidence of all this backroom drama gets substantiated when we just look at the Indian government’s bond yields market, where the ten-year yield spiked to a stark 6.85% in January.
Even the net surplus durable liquidity had fallen to just Rs 64,350 crore by late December 2024.
These are all drastic declines, and the basic principles of economics teach us that when there is less cash flowing through the system, economic activity slows down altogether.
When we further examine how India maintains its liquidity, we come across two primary ways.
The first is by running a trade surplus, which would bring in foreign exchange reserves. India, however, does not have that luxury at this time.
The second is by attracting foreign capital in the form of foreign direct investment (FDI) and foreign institutional investment (FII). But when global investors sense risk, whether it’s due to rising US interest rates or geopolitical uncertainty or even shaky domestic policies, these inflows take a hit, making the liquidity crisis even worse.
Key Asian markets in March 2024. Chart provided by authors.
And here’s where India’s long-term economic model presents a problem. Unlike China or South Korea, which built their economies on export-oriented industrialisation, India has largely relied on domestic consumption to drive growth. While that worked in the past, it’s proving to be a weak foundation now.
Without a globally competitive manufacturing base, India lacks a steady inflow of foreign earnings to balance out capital outflows. Instead of making exports more competitive, the RBI’s rigid currency policies have made Indian goods more expensive abroad, making them unattractive and limiting their global reach.
If India had a strong export foundation, it could better navigate liquidity crunches instead of depending so heavily on foreign capital inflows.
However, that’s not the end of the problem either. Simply flooding the system with liquidity isn’t the answer. Too much liquidity can always trigger inflation and asset bubbles, which can further push prices up and create instability, and that’s why striking the right balance is so important for the central bank.
With digital payments operating the way they are, old-school liquidity buffers aren’t enough anymore. Banks need smarter tools such as quicker forex swaps, long-term lending options with the RBI or even linking the cash reserve ratio with broader liquidity needs to prevent last-minute cash crunches.
Maybe liquidity rules should even be adjusted based on regional and sectoral demands, ensuring funds are available where they are needed most.
And then there’s the bigger question: how does India protect itself from sudden foreign fund outflows?
One possible solution is to create a strategic liquidity reserve that could serve as a buffer that can absorb external shocks without forcing the RBI to burn through its forex reserves.
India already has deep forex reserves to manage this, but they have seen a rapid depletion in managing the depreciative effect on the rupee. Still, the pumping out of FIIs as hot money needs greater accommodation. Foreign investment in the form of FDI is more stable, predictable and continuous, making a host currency less volatile.
A stable rupee is a less volatile rupee and excessive inflow or outflows of FIIs or FPIs will enhance volatility concerns, like we are seeing now.
Also, at the end of the day, India can’t afford to keep reacting to investment and liquidity crises as they arise. It needs a forward-looking strategy, one that ensures financial stability, less volatility of the rupee, sustains economic growth and builds resilience against external pressures.
Deepanshu Mohan is a professor of economics, dean, IDEAS, and director, Centre for New Economics Studies. He is a visiting professor at the London School of Economics and an academic visiting fellow to AMES, University of Oxford.
Ankur Singh is a research assistant with the Centre for New Economics Studies (CNES) and a team member of its InfoSphere initiative.