Context:
The 10-year government bond yield hit its lowest point in three years. However, contrasting this, corporate bond yields and certificate of deposit (CD) rates are on the rise.
- The interest rate spread between the repo rate and corporate bond yields has widened to 125 basis points (bps).
- The spread between government securities and corporate/state bonds has increased from 30–35 bps to 45–55 bps.
Why This Divergence?
Despite the RBI’s 25 bps rate cut, yields are rising due to a liquidity shortage in India’s financial system.
RBI’s Liquidity Management Measures
The Reserve Bank of India has employed several instruments to manage liquidity:
- Dollar-Rupee Buy-Sell Swaps:
- On March 24, the RBI is conducting a three-year, $10 billion swap auction, injecting approximately ₹86,000 crore.
- Similar swaps were conducted on February 28 and January 19 (a six-month, $5 billion swap).
- Variable Rate Repo (VRR) Auctions:
- The RBI conducts daily VRR auctions, supplying money to banks at market-determined rates.
- Open Market Operations (OMOs):
- In March, the RBI conducted ₹1 trillion worth of OMOs in two tranches (March 12 and March 18), buying government bonds from banks and providing liquidity.
Historical Context of Liquidity Cycles
- Tight liquidity phases (negative liquidity levels) occur during periods of tight monetary policy to combat inflation.
- Excess liquidity phases were seen post-2008 financial crisis and after COVID-19, when easy money policies were adopted.
- Currently, the RBI is attempting to promote growth by cutting rates, but liquidity shortages are preventing effective transmission.
Key Sources of Liquidity
- Cash Reserve Ratio (CRR):
- In December, the RBI cut the CRR by 50 bps to 4%, releasing ₹1.12 trillion into the system.
- Further scope is limited as the CRR floor is set at 3% by law.
- Open Market Operations (OMO):
- RBI buys bonds to inject liquidity or sells bonds to absorb excess funds.
- Currency in Circulation & Government Surplus Cash:
- During festivals, cash demand rises, tightening liquidity.
- Government spending patterns also affect system liquidity.
The Healthiest Liquidity Source
- Foreign Institutional Investors (FIIs) and Foreign Portfolio Investors (FPIs) bring in dollars, converting them into rupees.
- Recent data:
- FIIs pulled out ₹34,574 crore in February 2025, totaling ₹1.12 trillion outflows in the first two months of 2025.
- Since October 2024, the cumulative outflow is ₹2.12 trillion.
- Rupee Depreciation Factor:
- Between October 2024 and February 2025, the rupee depreciated by over 4%, moving from ₹83.81 to ₹87.50 per dollar.
- This deters foreign investments as US bonds offer 4.5% risk-free returns with lower currency risk.
- Rupee Recovery:
- The rupee strengthened to ₹85.98 per dollar recently, which may signal a return of foreign investors as stability returns.
Liquidity Requirements: Appropriate, Adequate, or Abundant?
For rate cuts to be effective, the RBI needs to ensure adequate liquidity.
- If liquidity is infused via OMOs, the RBI’s rupee balance sheet expands.
- If liquidity is infused via dollar-rupee swaps, the RBI’s foreign currency reserves increase.
As of January, $82.6 billion of India’s $640 billion forex reserves were short-term buy-sell swaps, deferring ₹7.5 trillion in liquidity withdrawal.
With the dollar index falling from 110 to 104 and the rupee strengthening, a blend of OMOs and long-term swaps is the most effective liquidity management strategy.
What’s Next?
- Even if the RBI cuts rates further in April, without ample liquidity, borrowers will not feel the impact.
- The RBI will need to continue balancing OMOs, swap rollovers, and foreign inflow encouragement to maintain stability.
- The return of FIIs and FPIs will be the key turning point for liquidity normalization.
