India is facing a liquidity crisis, one of the most severe in more than a decade. Despite repeated interest rate cuts by the Reserve Bank of India to stimulate economic growth, a tightening liquidity environment is impeding the transmission of these cuts to borrowers. In just a few years, the overall liquidity in the banking system—including government cash balances—has plunged from a surplus of Rs 3–4 lakh crore to a mere Rs 64,350 crore by late December 2024. This dramatic shift is raising serious concerns about the health of the financial system.
Liquidity is the lifeblood of the banking sector. It enables banks to lend, process transactions, and meet customer withdrawal demands. For consumers, it means ready access to their money. For businesses, it means borrowing at reasonable interest rates. Without adequate liquidity, the day-to-day functioning of banks is disrupted.
READ | Rhetoric and reality: Gender budget grows, but policy gaps remain
When banks experience a liquidity shortfall, they tighten credit and raise interest rates to attract deposits. This, in turn, makes borrowing more expensive and harder to access, eventually slowing down economic activity. A key sign of this distress is declining consumption—a growing concern for policymakers since last year. The daily liquidity deficit in the interbank market has ballooned from Rs 1 lakh crore in early January to over Rs 3 lakh crore, marking the steepest shortfall since 2010.
Reasons behind the liquidity crisis
One of the primary triggers of the current liquidity squeeze is the RBI’s intervention in the foreign exchange market. As the rupee faced heightened volatility in recent months, the central bank stepped in to stabilise it by selling dollars from its reserves. While this helped curb the rupee’s slide, it came at a cost: India’s forex reserves fell sharply from $700 billion in October to $623 billion by mid-January. These interventions effectively drained liquidity from the domestic market.
At the same time, the RBI has been deliberately tightening liquidity to combat inflation. By raising the Liquidity Coverage Ratio (LCR), the RBI has forced banks to hold a larger portion of their funds in high-quality liquid assets, such as government bonds. This has locked up nearly Rs 4 lakh crore—money that banks would otherwise use to extend credit.
Another contributing factor is the government’s shift to a “just-in-time” payment system, which replaced the earlier practice of advance fund transfers to states. This new system results in large sums sitting idle in government accounts, effectively removing liquidity from circulation.
The merger of HDFC and HDFC Bank has also strained liquidity. With HDFC’s legacy loans maturing, the newly merged entity has had to aggressively mobilise deposits to sustain lending, intensifying competition among banks for funds.
Meanwhile, a structural shift in household savings is underway. Consumers are increasingly favouring mutual funds over fixed deposits, reducing the inflow of funds into banks. The rise of digital payments platforms like UPI and RTGS has added another layer of complexity, making liquidity needs more volatile and unpredictable.
RBI response to liquidity crunch
To counter the crunch, the RBI has taken several steps to inject liquidity into the system. It recently conducted a three-year, $10 billion dollar-rupee buy-sell swap, pumping about Rs 86,000 crore into the market. Earlier, similar swaps were conducted on January 19 ($5 billion for six months) and February 28. Additionally, the RBI has stepped up its open market operations, purchasing government securities to infuse cash. In March alone, OMOs worth Rs 1 trillion were executed in two tranches.
Addressing the liquidity challenge will be a key task for Poonam Gupta, the newly appointed Deputy Governor of the RBI. She steps into her role at a time when the banking system has faced a liquidity deficit for four straight months, briefly turning into a surplus only recently.
What makes the current episode particularly difficult is the mismatch between the RBI’s monetary policy intent and market realities. While the central bank has been cutting rates to support growth, the lack of liquidity is preventing these rate cuts from having their intended impact.
The way ahead
The RBI may need to further reduce the Cash Reserve Ratio (CRR) or revise liquidity norms to free up more funds. Some are even calling for an additional interest rate cut—possibly up to 100 basis points—by the end of 2025. More fundamentally, India may need to rethink its liquidity management strategy. While the inflation-targeting framework adopted in 2014 has largely been successful, evolving market conditions demand a more dynamic and adaptive approach. Managing liquidity must go beyond controlling inflation—it must also ensure that the financial system is equipped to respond to modern liquidity shocks.
With banking now operating 24/7 due to the proliferation of digital payments, traditional liquidity buffers are no longer sufficient. Banks and regulators need smarter tools—more responsive forex swaps, longer-term refinancing options from the RBI, and a more flexible link between CRR and LCR requirements.
Banks may also need to revise their deposit mobilisation strategies to reflect changing consumer preferences. Encouraging savers to return to fixed deposits, even thoughincentives or innovative products, could help ease the crunch. The RBI, for its part, must encourage banks to prepare for liquidity cycles rather than scrambling during a crisis.
One of the most straightforward ways to restore liquidity—foreign capital inflows—has also faltered. In February, foreign institutional investors (FIIs) withdrew Rs 34,574 crore from Indian equities, bringing total outflows to Rs 1.12 trillion in the first two months of 2025, and Rs 2.12 trillion since October 2024. When FIIs and foreign portfolio investors (FPIs) invest in Indian markets, they convert dollars into rupees, directly boosting liquidity. A return of these investors could significantly ease the strain.
For now, the RBI may have little choice but to expand its balance sheet. If done through OMOs, its rupee balance sheet will grow; if done through forex swaps, its dollar balance sheet will expand. Either way, the central bank must act decisively to ensure that the monetary policy it sets can actually reach the people and businesses it’s intended to support.