The Reserve Bank of India could tighten financial conditions without relying entirely on repo-rate hikes. SBI Research has suggested raising the marginal standing facility rate by 25 basis points to 6% in the interim, followed by a 25-basis-point repo-rate hike in December. This would take the MSF rate to 6.25%, allowing the RBI to tighten in stages as inflation risks persist.

The proposal comes as banking system liquidity surplus has fallen from around ₹11.2 trillion in early September to about ₹2.6 trillion. The weighted average call money rate and the triparty repo rate have reached close to the 5.75% MSF rate.

The decline in surplus reflects foreign exchange intervention, ₹1.25 trillion of open market operation sales and other liquidity-draining measures. From the fortnight beginning October 16, banks must maintain at least 99% of their prescribed cash reserve ratio on a daily basis, up from 90%. The change reduces banks’ flexibility in managing reserves and is estimated to neutralise a liquidity buffer of ₹400–500 billion.

Festive-season currency demand, a potentially negative balance of payments in the second half of 2026-27 and further foreign exchange-related drains could push system liquidity into deficit. This gives the RBI scope to influence overnight borrowing costs without immediately raising the repo rate.

Reversing the COVID-era strategy
During the COVID-19 period, abundant surplus liquidity allowed the reverse repo rate to become the effective operating rate for a time, keeping overnight market rates below the repo rate. As liquidity tightens, the reverse mechanism could work in the RBI’s favour.

The WACR can move towards the repo rate and, if funding pressures persist, towards the MSF ceiling. By not fully replacing liquidity withdrawn through foreign exchange intervention, CRR changes and bond sales, the RBI can allow overnight rates to rise without an equivalent increase in the policy rate.

With the MSF rate currently at 5.75%, overnight rates moving towards this ceiling could deliver around 25 basis points of additional tightening relative to the repo rate. The impact on lending rates, however, would depend on the persistence of higher funding costs and their transmission through banks.

SBI Research’s proposal would formalise this approach by raising the MSF rate to 6% before the December repo-rate increase. The subsequent 25-basis-point repo hike would take the MSF rate to 6.25%. This would raise the cost of marginal overnight borrowing while phasing the broader policy response.

Balancing inflation and funding risks

The approach could be relevant if October inflation surprises on the upside. Instead of immediately resorting to an off-cycle repo-rate increase, the RBI could allow tighter liquidity to push overnight rates higher while assessing whether price pressures are temporary or becoming entrenched.

Liquidity tightening is not equivalent to a repo hike. A repo increase changes the policy benchmark, while liquidity-driven tightening works through funding conditions and can be less predictable. A sustained deficit could force banks to compete more aggressively for deposits, raising funding costs and lending rates beyond the intended degree of restraint.

The 2013 taper-tantrum episode illustrates the risks. The RBI raised the MSF rate by 200 basis points to 10.25% and restricted access to its liquidity adjustment facility, pushing short-term rates sharply higher. But the banking system was already in deficit, foreign exchange reserves were around $280 billion and inflation was close to 10%. The current setting, with reserves around $735 billion and inflation at 4.8% in the cited comparison, differs materially.

The RBI must therefore calibrate the pace of liquidity withdrawal and the level of overnight rates it is willing to tolerate. If funding conditions become disorderly, liquidity injections would remain an option.

Liquidity management cannot replace repo-rate action if inflation becomes persistent. But it gives the RBI an additional lever to tighten financial conditions in stages, potentially limiting the need for a sharper increase in the policy rate.