India’s banking sector is grappling with a significant liquidity crunch, one that threatens not only financial stability but also the broader economy. The liquidity deficit, which has persisted since mid-December, is forcing banks to borrow more from the central bank, driving up borrowing rates. If left unaddressed, this could worsen the slowdown in India’s economic growth. In early January, the average daily deficit stood at around Rs 1,50,000 crore, reflecting a growing shortfall in liquidity. Meanwhile, core daily liquidity, a more stable measure of liquidity, dropped sharply from Rs 4,60,000 crore in September to just Rs 30,000 crore in early January.

This decline has been largely driven by the Reserve Bank of India’s (RBI) interventions in the foreign exchange market, where it has been selling dollars to manage rupee depreciation. While these interventions are crucial for stabilising the rupee, they have drained liquidity needed for domestic economic activity. As a result, banks have less capital to lend, raising borrowing costs. Elevated rates are already starting to impact lending and could further strain sectors that are already struggling. The banking sector’s concerns are valid. In a recent meeting with Reserve Bank of India (RBI) officials, bankers called for measures like longer term variable rate repos, FX swaps, and open market bond purchases. A temporary reduction in the cash reserve ratio (CRR) could also ease pressure on banks and help maintain lending levels.

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These measures would provide some relief, but each comes with trade-offs, such as the risk of inflationary pressures or market distortions. There is also a broader concern about the longer-term implications of these liquidity measures. While short-term interventions may stabilise the system, excessive reliance on such measures could distort market signals and lead to an unhealthy dependence on the central bank. It’s essential to focus on structural solutions, such as boosting domestic savings, attracting stable foreign investments, and improving market efficiencies, to reduce the banking system’s dependence on RBI interventions. Additionally, the ongoing depreciation of the rupee is a concern for businesses with unhedged exposures.

The currency’s volatility is not only negatively affecting importers but also contributing to uncertainty in the market. As the rupee hits new lows, businesses face higher costs, potentially squeezing margins and affecting investment. The RBI’s challenge is balancing the need for currency stability with maintaining sufficient liquidity in the banking system. Its interventions are essential but must be managed carefully to avoid exacerbating liquidity pressures or causing inflation. The central bank must take swift action to address these issues, but it must do so in a way that doesn’t undermine India’s fragile economic recovery. While stabilising the rupee is critical, the RBI must also ensure that liquidity pressures are alleviated to keep the economy moving forward. A careful, balanced approach is necessary to support both currency stability and economic growth.