Liquidity and Its Implications on the Fixed Income Market

 Overview

System liquidity, which comprises banking liquidity and government cash balances, has tightened significantly in FY25, shifting into deficit by mid-January from a surplus of approximately Rs 4.5 lakh crores in September 2024. The Reserve Bank of India’s (RBI) interventions in the foreign exchange (Fx) market to stabilize the rupee and capital outflows from the equity market have led to a major liquidity drain.

Key Developments

• RBI has actively employed Variable Rate Reverse Repos (VRRs) to provide temporary liquidity relief.

• Recent measures such as Cash Reserve Ratio (CRR) cuts, Open Market Operations (OMOs), and Fx swaps indicate a shift toward increasing durable liquidity.

• Despite the banking liquidity deficit, RBI’s interventions have ensured that daily Triparty Repos (TREPs) remain close to the policy repo rate.

• Historically, liquidity improvement has coincided with rate easing cycles, suggesting potential easing ahead.

• In FY26, in the absence of substantial Foreign Portfolio Investment (FPI) or Foreign Direct Investment (FDI) inflows, RBI is expected to rely on OMO purchases to inject liquidity, a strategy observed in 8 of the last 12 years.

Key Factors Impacting System Liquidity

1. Currency in Circulation (CIC): Increasing CIC negatively affects liquidity as physical cash remains outside the banking system.

2. Incremental Cash Reserve Ratio (CRR): Higher CRR requirements constrain liquidity by mandating banks to maintain more reserves with RBI.

3. RBI Dividend: The annual dividend paid by RBI to the government provides liquidity infusion.

4. Government Securities (G-Secs) Maturity: The redemption of G-Secs held by RBI drains liquidity as proceeds flow back to the central bank.

5. Forex Interventions: RBI’s actions in the Fx market, whether buying or selling foreign currency, directly impact liquidity.

6. Open Market Operations (OMO): RBI’s bond purchases inject liquidity, whereas sales absorb excess liquidity.

System Liquidity Framework

System liquidity is the sum of banking liquidity and government cash balances. While banks and the government cannot directly influence system liquidity, RBI plays a crucial role in managing it through various monetary policy tools.

Seasonal Trends in Currency in Circulation (CIC)

• CIC typically peaks between February and April due to increased cash demand.

• Liquidity sees an inflow between June and September, linked to the harvest season.

• The festive season (October-November) triggers higher outflows.

RBI's Liquidity Management Measures

1. Cash Reserve Ratio (CRR) Adjustments

• CRR influences liquidity based on Net Demand and Time Liabilities (NDTL) and RBI’s prescribed rate.

• A CRR cut, as seen in FY25, adds liquidity, whereas a rise tightens it.

2. RBI Dividend Payouts

• RBI’s dividend to the government has surged, with FY25 witnessing a sharp rise due to high global yields and foreign exchange operations.

3. G-Sec Holdings and Maturity

• RBI holds about Rs. 13.9 lakh crores in G-Secs, with maturities set to reduce liquidity in FY26.

• Unlike previous years, no switch operations have been undertaken recently, increasing the maturity burden.

4. Foreign Exchange (Fx) Interventions

• Fx interventions have significantly influenced liquidity, with RBI absorbing nearly Rs. 3 lakh crores of INR liquidity from October to December 2024—the highest in a decade.

5. Open Market Operations (OMO)

• OMOs are a recurring liquidity tool, with RBI expected to conduct Rs. 2-3 lakh crores in purchases in FY26.

• Given the large G-Sec maturities in RBI’s books, OMOs will remain a critical liquidity management tool.

Conclusion

• Liquidity management will be a focal point in FY26, particularly as rate cuts typically align with liquidity improvement.

• RBI is expected to use OMOs extensively to maintain system liquidity.

• The trajectory of FPI and FDI inflows will be a determining factor in liquidity trends.

• If RBI opts for a more accommodative liquidity stance, additional OMO purchases may be implemented.

Final Thoughts

Understanding system liquidity is vital for navigating the fixed income market. As RBI balances various factors—including CIC, CRR, dividends, Fx interventions, and OMOs—market participants should closely monitor policy actions and global liquidity trends to anticipate future movements in interest rates and bond yields.