RBI faces a liquidity test as surplus swells; temporary tools may offer best response: IDFC FIRST Bank

The Reserve Bank of India’s next challenge in liquidity management may be less about the quantum of surplus and more about choosing the right instruments to absorb it.

According to a report by IDFC FIRST Bank, with the current build-up expected to be temporary, short-term Treasury Bill issuances under the Market Stabilisation Scheme and dollar/rupee sell-buy swaps appear better suited than durable liquidity absorption measures.

These instruments would allow the RBI to drain excess cash without locking the banking system into tighter conditions just as seasonal currency leakage begins reversing the surplus in the second half of 2026-27.

IDFC FIRST Bank estimates that the liquidity surplus has expanded rapidly following the RBI's three foreign exchange swap windows for FCNR(B) deposits, external commercial borrowings and overseas foreign currency borrowings. Dollar inflows had reached $72.8 billion by August 21, with 90% coming through FCNR(B), and could rise to $116 billion by December. The associated FX operations lifted core banking system liquidity surplus to 8.1 trillion rupees as of August 14 from 4.7 trillion rupees on June 5, with the surplus projected to peak at 9.9 trillion rupees in September.

For now, IDFC FIRST Bank notes, the RBI has relied on variable rate reverse repos, which were absorbing nearly half of the surplus liquidity in August. This has helped contain the impact on money market rates, although the weighted average call rate averaged around 5.14% and the TREPS rate 5.0%. The RBI's operational objective has been to keep the WACR close to the repo rate while narrowing the gap with TREPS, but this task will become more difficult if the liquidity surplus rises further as projected in September.

The case for using temporary instruments rests on the expected evolution of liquidity itself. The bank projects core liquidity to decline to ₹5.4 trillion by March 2027, or about 1.8% of net demand and time liabilities. Such a surplus is not necessarily excessive, particularly when government cash balances are high and can periodically drain banking system liquidity. More than half of the ₹8.1-trillion core surplus as of August 14 was accounted for by government cash balances of ₹4.3 trillion.

Currency leakage could provide a significant automatic drain, it said. According to IDFC FIRST Bank's estimates, it could total ₹5.2 trillion in 2026-27, against ₹4.5 trillion in 2025-26, with 76% of the full-year leakage expected in second half of 2026-27. This seasonal pattern argues against deploying measures designed to permanently impound liquidity when the surplus may recede substantially without such intervention.

Three-month MSS bills would therefore offer the RBI a relatively precise means of absorbing surplus for a limited period, while sell-buy swaps could similarly withdraw rupee liquidity through the FX market, it said. IDFC FIRST Bank said the choice and calibration of these tools would matter for both the money market and the sovereign yield curve, with the management of the temporary liquidity build-up likely to affect the shape of the yield curve and short-term interest rates.

The stakes are higher because IDFC FIRST Bank expects the second half of 2026-27 to see increased government bond supply. Net Centre and state bond supply is estimated at ₹12.5 trillion, compared with ₹9.4 trillion in the first half of 2026-27, while the large liquidity surplus leaves little room for RBI OMO purchases.

The RBI, therefore, faces a balancing act: absorb enough liquidity to preserve monetary policy transmission and anchor overnight rates near the repo rate, while avoiding measures that could over-tighten conditions ahead of an expected seasonal decline in surplus. Hence, temporary liquidity management tools may offer the RBI greater flexibility in navigating this phase, said IDFC FIRST Bank.