India's record diaspora inflows swamp banks, test RBI tools

India drew a record $127 billion from its vast diaspora, surpassing even the most optimistic estimates and giving policymakers a bigger war chest to defend the currency.

Now comes the hard part: managing the flood of cash.

The inflows have helped push surplus liquidity in the banking system to nearly Rs 10 lakh crore ($106 billion), a five-year high, as lenders received rupees for the dollars they swapped with the Reserve Bank of India (RBI).

The glut has driven the overnight rate below the central bank’s benchmark rate, undermining its monetary policy aim. The size of the inflows could prompt the RBI to turn to longer-term measures to soak up the excess cash from the banking system after relying largely on short-term tools so far.

The central bank will meet select lenders later on Thursday to discuss liquidity management measures, according to people familiar with the development. An RBI spokesperson did not immediately respond to an email seeking comment.

The RBI could use longer-term variable reverse repo auctions, or VRRRs, to mop up surplus cash. It recently held a 15-day reverse repo auction and has used the tool to drain cash for up to 56 days in the past. However, banks have shown limited interest in longer period, which may dent the measure’s efficacy. Another option is a calendar of shorter-term VRRR auctions, according to DBS Bank Ltd.

Cash Management, Treasury Bills

The RBI can also use shorter-tenor cash management bills and raise issuance of treasury bills. It could announce such measures before the end of the month, according to Upasna Bhardwaj, chief economist at Kotak Mahindra Bank.

Incremental Cash Reserve Ratio Hike

Another option is raising the cash reserve ratio on the additional deposits collected by banks over a specific period. The RBI had deployed this tool in 2023 to absorb excess liquidity after 2,000-rupee notes returned to the banking system.

The move would have an immediate impact, but could be seen as reversing the RBI’s earlier decision to exclude these deposits from the statutory reserve requirements, according to Radhika Rao, senior economist at DBS Bank. The amount banks have to set aside could be proportional to the increase in net deposits, she said.

Take Delivery of Short Forward Book

The RBI’s short-dollar book has surged to a record $136 billion, primary due to the future dollar obligations from the deposit inflows.

“The RBI may be comfortable now taking delivery of its forward book which is due for maturity in one year given the liquidity influx,” said Madhavi Arora, chief economist at Emkay Global Financial Services.

RBI can conduct sell-buy forex swaps in which it sells dollars to banks and takes out rupee liquidity. The process is reversed after a pre-decided period. The central bank is likely to remain cautious in deploying this tool in the near term as global uncertainty warrants preserving adequate FX reserve buffers, Kotak’s Bhardwaj said.

This tool can mop up liquidity without distorting the FX forward curve, but could push up yields at a time when global bond markets are witnessing a selloff.

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