Moneycontrol Pro Panorama| Sanjay Malhotra’s tough liquidity test

The fundamental dilemma facing Malhotra is simple: inject too much liquidity, and inflation could spiral; inject too little, and the banking system chokes.

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Liquidity in the banking system is like a double-edged sword. Too much of it floating around can fuel inflation. Too little can cause panic and spike short-term rates.

Managing this is not an easy task for any central bank governor.

Unfortunately, that is precisely the situation the new Reserve Bank of India (RBI) chief Sanjay Malhotra finds himself in.

Let’s understand the numbers first.

According to the RBI’s latest data, the banking system’s liquidity deficit stands at Rs 2.1 lakh crore. This is attributed to the central bank’s aggressive intervention in the currency market, which drained liquidity.

That apart, slowing government spending too has further strained liquidity. Thus, since December, the liquidity deficit has consistently hovered above Rs 1 lakh crore.

First big test for Malhotra?

Malhotra took charge as the Governor of the Reserve Bank of India (RBI) on December 11, 2024, stepping into an environment fraught with liquidity constraints and volatile money markets. In just over two months, the RBI has injected a staggering Rs 49.18 lakh crore into the banking system through a mix of short-term and durable liquidity measures.

Since December, Malhotra has overseen a series of liquidity operations to ease the funding crunch faced by banks.

These include Rs 18.27 lakh crore in normal variable rate repo (VRR) auctions, Rs 29.46 lakh crore in daily VRR auctions, Rs 1,00,020 crore in open market purchases, and a foreign currency buy-sell swap worth Rs 45,000 crore.

Despite these interventions, liquidity deficits have swung wildly, from Rs 30,000 crore on some days to Rs 3 lakh crore on others between mid-December and mid-February.

Adding to the pressure were tax outflows exceeding Rs 3 lakh crore in December, which drained cash from the system. Even a CRR cut from 4.5 percent to 4 percent, which released Rs 1.16 lakh crore, was insufficient in the face of persistent liquidity stress and the RBI’s massive $75 billion forex intervention to stabilise the rupee.

The fundamental dilemma facing Malhotra is simple: inject too much liquidity, and inflation could spiral; inject too little, and the banking system chokes. Too much liquidity tightening can push up short-term rates and can have an impact elsewhere in the financial system.

That’s what we call a trap

The weighted average call money rate—a key benchmark for short-term borrowing—has consistently traded above the RBI’s repo rate of 6.5 percent, reflecting the strain in the system.

Ordinarily, a tight money market signals the need for liquidity infusion. But India’s case is trickier. While liquidity appears tight, inflation remains a lurking threat, and a flood of rupees into the system could exacerbate price pressures.

Moreover, with government borrowing elevated and the fiscal deficit high, excess liquidity could push bond yields lower, complicating debt market dynamics.

Unlike his predecessor, Shaktikanta Das, who enjoyed a relatively stable monetary environment for much of his tenure, Malhotra faces a fast-changing liquidity landscape.

The measures announced so far suggest he is inclined towards an active liquidity management approach, willing to step in frequently rather than relying on passive tools.

The Rupee conundrum

But frequent interventions also raise the risk of policy miscalculation. The RBI’s two dollar-rupee swap auctions—one for $5 billion in January and another for $10 billion scheduled for February 28—aim to inject durable liquidity, yet they also expose the RBI to potential currency volatility if global conditions shift.

Meanwhile, the government’s cash balances and tax collections in the coming months will be crucial in determining whether the liquidity crunch persists.

For now, Malhotra has signalled his intent: the RBI will provide as much liquidity as needed, while keeping a close watch on inflation. Whether this strategy holds or backfires will define his early tenure. One thing is certain—The new RBI governor has no honeymoon period.

Also, read today’s Chart of the Day that shows falling inflation gives more room for the MPC to cut rates. Also, R Sreeram has an interesting take on hospital stocks which he says are now valued at par or higher than consumer staples companies.

Wish you all a good week ahead.

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