The financial markets are currently experiencing a liquidity squeeze, prompting the Reserve Bank of India (RBI) to intervene. Over the past week, a combination of factors has shifted the banking system’s liquidity into deficit, albeit what is considered to be a temporary phase. In response, the RBI has acted swiftly, injecting approximately Rs 1 lakh crore through variable repo rate auctions (VRR). This move underscores the central bank’s commitment to maintaining stability in the financial system during times of stress.

Roots of the Current Squeeze

Several converging factors have contributed to this liquidity tightening. The Indian rupee’s continued depreciation against the US dollar is a primary concern, compelling the RBI to potentially sell dollars to stabilise the currency, thus draining rupee liquidity. Foreign portfolio investors (FPIs) are also pulling out funds, driven by concerns about high valuations in emerging markets and more attractive yields in US treasuries. A perceived slowdown in government spending has only compounded the issue, further reducing the flow of funds in the system. These factors, when put together, have created a situation where liquidity has moved from a surplus of Rs 1.04 lakh crore on November 19 to a deficit of over Rs 30,000 crore by November 27.

Rates Under Pressure, MPC Dilemma

The impact of tight liquidity is already visible in money market rates. The weighted average call money rate, the rate at which banks lend to each other overnight, has risen above the RBI’s repo rate. This increase signals upward pressure on interest rates across the board if the liquidity deficit persists. This situation adds complexity to the upcoming Monetary Policy Committee (MPC) meeting next week. While there is a growing clamour, especially from government circles, for interest rate cuts to stimulate growth, the recent jump in retail inflation and the current liquidity conditions present a challenge. The MPC faces a tough choice: cut rates prematurely and risk inflation, or hold steady and risk dampening already fragile economic growth. A token rate cut to signal intent is a possibility, but a decisive move seems unlikely at this juncture given the mixed signals from the economy.

Microfinance Stress Signals Broader Issues

The liquidity squeeze and broader economic uncertainties also cast a shadow on sectors like microfinance. ESAF Small Finance Bank’s recent acknowledgement of asset quality stress, particularly in its microfinance portfolio, highlights these challenges. As reported by CNBC-TV18, factors like over-indebtedness and the lingering impact of the pandemic are straining the sector. Rising delinquencies in microloans, especially in rural areas, suggest that the economic pain is not uniformly distributed and pockets of stress are emerging. This situation warrants close monitoring, as stress in the microfinance sector can have wider implications for financial inclusion and rural credit.

Will the RBI’s liquidity injection be enough to stabilise the markets and ease the pressure on interest rates? Much will depend on how long the factors driving the deficit persist. If FPI outflows continue and the rupee remains under pressure, the RBI may need to take more sustained measures to ensure liquidity and market stability. For now, markets will be keenly watching the MPC’s decision next week and its guidance on the future path of interest rates and liquidity management.