CRR Hike May be RBI’S Cleanest Option to Drain Liquidity – I-Sec PD

By BasisPoint Insight

The Reserve Bank of India may need to use a cash reserve ratio increase as the primary tool to absorb the liquidity overhang created by large foreign-currency deposit inflows, even though such a move could raise concerns over banking-sector signalling and credit conditions, ICICI Securities Primary Dealership said in a report released this week.

The report said the RBI could combine a 1 percentage point CRR increase with about ₹2 trillion of short-end open market operation sales to bring durable and system liquidity closer to levels the central bank may be comfortable with by the end of 2026–27.

A 1 percentage point increase in CRR would absorb about ₹2.7 trillion of durable liquidity, the report said. Short-end OMO sales could absorb another ₹2 trillion, leaving the RBI with a more manageable surplus after the surge in inflows under the foreign currency non-resident deposit scheme and related windows.

Liquidity Overhang

The RBI’s FCNR(B) scheme, announced in June, closed at the end of August with inflows of $127 billion. Including mobilisation through other channels such as external commercial borrowings and overseas foreign currency borrowing, total inflows could exceed $140 billion.

That is nearly 2.5 times the report’s initial estimate and more than double the inflows received in 2013 under a similar scheme as a share of gross domestic product, ICICI Securities Primary Dealership said.

The report said the stronger-than-expected inflows appeared to have exceeded the RBI’s own expectations and may have been one reason the FCNR swap window was closed early. The swap windows for ECBs and overseas foreign currency borrowing remain open.

The immediate challenge is liquidity management. The liquidity adjustment facility surplus had already crossed ₹10 trillion earlier this week and may rise further. System liquidity has remained in surplus through most of the current financial year, ICICI Securities Primary Dealership said.

Core or durable liquidity surplus, defined as system liquidity surplus plus the government’s cash balance, stood at ₹8.06 trillion as of Aug 15 and could cross ₹15 trillion by the end of September on a ceteris paribus basis, the report said. After accounting for foreign exchange outflows through spot intervention, forward deliveries and CRR requirements, core liquidity could still end September around ₹13 trillion-₹13.5 trillion, after possibly crossing ₹14 trillion intra-month.

System liquidity surplus could peak above ₹10 trillion and may remain around ₹8 trillion-₹8.5 trillion by the end of September, the report said.

Why CRR Leads

ICICI Securities Primary Dealership estimated that the excess liquidity overhang requiring sterilisation is around ₹4 trillion-₹5 trillion. The report said this surplus may need to be sterilised for at least 12 months and possibly up to 24 months before normal liquidity drivers absorb it.

That makes CRR attractive because it drains liquidity in a durable, direct and fully controlled manner. Unlike market-based operations, a CRR increase can remove liquidity from the banking system quickly and can also be reversed quickly when the RBI wants to release liquidity.

The report also made a broader financial stability argument for using CRR as the primary absorption tool. OMO sales and Market Stabilisation Scheme securities do not fully sterilise liquidity from the financial system because the securities remain tradeable and can be used as collateral. CRR, by contrast, locks away bank reserves and is therefore more effective in cooling excess money-market liquidity and broad money expansion.

The report said such sterilisation has become more relevant because the banking system was already in surplus before the FCNR inflows, credit growth remains strong, and the merchandise trade deficit is widening.

The Objections

The report identified three main objections to using CRR.

First, the RBI had cut CRR to 3% last year, which was widely treated as a durable easing step. But the report said 3% should be seen as a de facto floor rather than a permanent commitment. It argued that the central bank should retain flexibility to use all available instruments when liquidity conditions change.

Second, a CRR hike could send a negative signal to banks and may be viewed as a constraint on credit growth. The report said this concern is mitigated by strong credit growth and by the scale of surplus liquidity still likely to remain even after a CRR increase. Even after a 1 percentage point CRR increase, system liquidity would likely remain in surplus by ₹6 trillion-₹8 trillion.

Third, a broad CRR increase would affect all banks, including those that did not raise large FCNR deposits. The alternative would be an incremental CRR on liabilities raised after the FCNR scheme was announced. But the report said an incremental CRR could be very steep, possibly 25% or more, and may undermine the economics of raising these deposits. Since the RBI is trying to address a system-wide liquidity surplus, a broad measure may be more appropriate than a targeted one, it said.

VRRR Limits

The RBI has been using variable rate reverse repo auctions of different maturities to absorb surplus liquidity. Under the revised liquidity management framework announced in August 2025, seven-day VRR and VRRR operations are the primary tool, with overnight to 14-day operations used for transient liquidity management.

The report said these operations have not achieved the objective of aligning the weighted average call rate with the repo rate. The WACR has been below the 5.25% repo rate since July 31 and is more likely to stay near the 5.00% standing deposit facility rate under current surplus conditions.

Other overnight secured rates, including TREPS and market repo, averaged around the SDF rate in August and have now fallen decisively below it, the report said.

Longer-tenor VRRRs could be tried, but may not be reliable in India’s market structure. Banks may be reluctant to offer funds for three-month or six-month absorption operations unless they receive flexibility. But allowing premature withdrawal would reduce the RBI’s control over the amount and duration of sterilisation, the report said.

On Friday, the RBI announced a 30-day VRRR auction for Sep 7 with an exit option.

One possible improvement would be to allow non-bank participants such as mutual funds, insurers and other money-market entities into longer-term VRRRs, making the instrument closer to the US Federal Reserve’s reverse repo facility. But the report said it is unclear whether the RBI is considering such a step.

OMO and Swap Options

Foreign exchange swaps are another possible tool. The RBI already has around $32 billion of forwards maturing over the next 12 months, and it could conduct sell-buy forex swaps, selling dollars now and buying them back after six, 12 or 18 months.

But the report said this would depend on the market’s ability to absorb the flows and could affect forward premia, hedging behaviour and the spot exchange rate. The RBI would ideally use forex operations to stabilise the currency market rather than primarily to manage rupee liquidity, it said.

OMO sales are better suited to durable liquidity management. ICICI Securities Primary Dealership estimated that the RBI holds around ₹1.2 trillion of bonds maturing between September 2027 and September 2028. Extending the maturity bucket to June 2029 raises the stock to ₹2.9 trillion.

The report said the RBI should stick to short-end maturities for OMO sales because the liquidity inflow itself is expected to reverse after three to five years. Banks flush with FCNR-related deposits may also be more willing to buy short-term assets. Selling longer-duration bonds could put pressure on the broader yield curve, which is already facing global spillovers and expectations of possible RBI rate increases.

MSS Remote

The report said there is market discussion around using the Market Stabilisation Scheme to absorb liquidity, but it saw this as a remote possibility.

MSS securities are issued by the government, with the proceeds kept in a separate deposit with the RBI. The interest cost is borne by the government. In a year of fiscal strain, the report said it would be unusual for the government to bear an additional cost to help the RBI sterilise liquidity.

The original rationale for MSS has also weakened after the introduction of the standing deposit facility, which allows the RBI to absorb unlimited uncollateralised deposits from banks. The report said the government may reasonably expect the RBI to exhaust its own instruments before turning to MSS.

Policy Takeaway

ICICI Securities Primary Dealership said the RBI may need to move beyond regular liquidity operations because the current surplus is durable rather than transient. It said the most practical mix would be a 1 percentage point CRR increase and about ₹2 trillion of short-end OMO sales.

The report also said there may be a case to move away from the 1% of net demand and time liabilities yardstick for maintaining system liquidity surplus if the RBI is likely to raise rates in coming meetings, possibly as early as the October policy review. For now, however, the immediate issue is sterilising the FCNR-driven liquidity overhang without disrupting the bond market or weakening control over overnight rates.