The Reserve Bank of India's (RBI) recent liquidity injection measures, announced to address a significant Rs 2.9 lakh crore liquidity deficit, are set to recalibrate the financial system but may not entirely resolve the shortfall. Analysts believe these steps, while substantial, could serve as a precursor to further easing measures, including potential rate cuts in February.

"We expect the RBI to commence the rate easing cycle with a 25bps rate cut, reflecting the current domestic growth-inflation dynamics. In addition, we expect the central bank to add durable liquidity and keep a close watch on currency to limit excessive volatility. We hold to our view of the MPC embarking on a shallow rate easing cycle from the February 7 policy meeting. We expect the MPC to retain its neutral stance. Consensus is also penciling in a rate cut from February," a report by MS Research said.

The RBI measures

The RBI unveiled a three-pronged approach, consisting of Rs 600 billion in open market operations (OMO) purchases, Rs 500 billion through a long-dated variable rate repo (VRR) auction, and a $5 billion buy/sell swap auction. These measures aim to bring immediate relief to liquidity constraints but are unlikely to eliminate the deficit entirely. Nomura estimates that the banking system will remain in deficit, necessitating further interventions such as additional FX swaps and longer-dated VRRs.

The scale and timing of these measures surprised markets, as most participants did not anticipate OMO auctions before April. The Rs 600 billion OMO plan alone covers nearly 40% of the Rs 1.57 trillion in bond supply remaining until April, drastically altering the supply-demand dynamics, especially for government securities in the 3-10 year range. This is expected to support long-term bond yields, aligning with RBI’s proactive approach to easing.

In addition to OMOs, the extended duration of the VRR auction offers banks operational flexibility, helping them better manage liquidity. The $5 billion FX swap, while consistent with market expectations, was implemented with a shorter six-month tenor to address the elevated FX premia efficiently.

"Beyond articulating the current policy priorities, this also may broadly shape the incremental policy actions from the RBI. Given the evolution of seasonality in currency circulation and the current muted inflow expectations through the portfolio route, it clearly requires a series of such core liquidity infusion measures to sustain overnight settings around the policy repo, said, Rajeev Radhakrishnan, CIO – Fixed Income, SBI Mutual Fund.

Impact on monetary policy and economy

Analysts from Emkay Global suggest that these liquidity measures are more impactful than an immediate rate cut, as they directly influence market rates and provide a quicker transmission mechanism. However, they caution that liquidity injections alone may not be enough to stimulate India’s slowing economic growth. Complementary actions, such as easing lending restrictions on banks and non-banking financial companies (NBFCs), especially for unsecured loans, will be crucial to reviving retail credit and consumption in the second half of 2025.

Nomura maintains its view of a 25-basis-point rate cut in February, followed by further reductions totaling 100 basis points this year. Such monetary easing, coupled with liquidity enhancements, could create a more conducive environment for growth. However, with fiscal space limited, these measures need to play a pivotal role in counteracting economic sluggishness.

Challenges ahead

Despite the RBI's efforts, the banking system’s liquidity is expected to remain in deficit. Analysts foresee additional interventions in the form of further FX swaps and VRRs. The short-term market reaction to these measures has been modest, with yields rallying by 5-10 basis points at the short end and 2-3 basis points at the long end. However, a stronger rally at the short end is anticipated as the RBI continues to address liquidity constraints.