The focus of liquidity management has been on making the transmission of rate cuts faster and more effective. RBI has front-loaded liquidity infusion primarily via open market operations (OMO) purchases or purchases of government securities (g-secs), totaling ₹5.3 trillion spread-over 5 months. To put the speed of the infusion in perspective, during the Covid-19 pandemic RBI took one-year to conduct the same quantum of OMO purchases.
The drastic change in liquidity management was triggered by monetary policy focus shifting firmly towards supporting growth, as inflation risks subsided. Headline CPI (Consumer Price Index) inflation eased below the target rate of 4% in February 2025, after staying above the target rate for years. As monetary policy is forward-looking, inflation outlook is important.
On this front too comfort was drawn from expectation of strong crop output and core inflation remaining near historical lows. Hence monetary policy focus has firmly shifted towards supporting growth. RBI liquidity management is playing a key role to ensuring that liquidity conditions are conducive for the rate cuts to be transmitted. The durable liquidity infusion has resulted in banking system liquidity surplus rising to ₹1.6 trillion in May 2025 (average for the first half of the month) or 0.7% of net demand and time liabilities (NDTL), the total amount of money a bank owes to its customers. This is in sharp contrast to deficit liquidity conditions which persisted over the December 2024 to March 2025.
The next logical question is whether the current liquidity conditions are enough to ensure transmission of rate cuts. The Governor already has provided some insight on this stating 1% of NDTL as sufficient liquidity. This would translate into ₹2.7 trillion of system liquidity surplus. This indicates that surplus liquidity will need to rise further to ensure transmission of rate cuts. In this context RBI dividend to the Centre is being closely watched. This is a significant infusion of durable liquidity by boosting government expenditure.
Indeed, system liquidity is expected to peak at 1.7% to 1.8% of NDTL in August 2025 and then moderate to 0.5% of NDTL by March 2026. Hence, even with the 1% NDTL metric, RBI will need to infuse more durable liquidity to ensure liquidity surplus is sufficient for transmission. We estimate that RBI would need to conduct OMO purchase worth ₹1.6 trillion in June to March 2026. This will keep system liquidity at 1% to 1.2% of NDTL by March 2026.
But is 1% of NDTL enough to ensure transmission of rate cuts quickly and effectively? To assess this, we look at past rate cutting cycles. The components needed for transmission are more than 1% of NDTL liquidity and fall in credit-to-deposit ratio. In the 2015 to 2017 rate cut cycle, system liquidity had risen to 2.4% of NDTL by the end of the rate cutting cycle. Credit to deposit ratio had reduced to 72.3% by the end of the rate cutting cycle from 76.3% at the start. Repo rate during this period reduced by 2% and transmission was strong on both credit and deposit rates. Weighted average lending rates were lower by 1.22% and deposit rates by 1.95%.
Meanwhile, transmission during the February 2019 to October 2019 rate cut cycle, when repo rate was cut by 1.35% was limited. Weighted average lending rate remained broadly unchanged and deposit rates were lower by 0.17%. System liquidity surplus during this period rose to 1.4% of NDTL by the end of the rate cutting cycle. Credit-deposit ratio saw a more moderate drop to 76% from 78% at the start of the rate cut cycle.
In the current rate cutting cycle, credit-to-deposit ratio remains at the higher end at 78% (ex. Merger impact). The external benchmark regime will be a key support for transmission on lending rates. Around 72% of the loans are linked to external benchmarks. However, from transmission on deposits to take place system liquidity surplus will need to be in excess of 1% of NDTL.
-The author, Gaura Sengupta, is Chief Economist at IDFC First Bank. The views are personal.
(Edited by : Unnikrishnan)