India’s banking system is carrying a liquidity surplus of more than ₹11 trillion, created when the Reserve Bank of India absorbed $132.98 billion in FCNR(B) deposit inflows under its special swap scheme, along with approximately $3 billion in external commercial borrowings under the broader facility window. The transactions released an equivalent amount of rupee liquidity into the banking system.

Much of this surplus is being absorbed overnight through the RBI’s Standing Deposit Facility at 5% and variable-rate reverse repo auctions. It is not financing productive activity. Instead, it sits on bank balance sheets, earning less than the cost of the foreign currency liabilities that helped generate it. If the overhang persists over the next three to six months, it could complicate the RBI’s management of both liquidity and inflation.

The FCNR(B) scheme was a deliberate response to external-sector stress: a weakening rupee, pressure on usable reserves and an oil import bill aggravated by the Iran war and disruptions in the Strait of Hormuz, which the IEA has characterised as the largest oil supply shock in history. Whether debt was the appropriate instrument when reserves stood at $682 billion is a legitimate question. This article takes the scheme as given and focuses instead on managing its near-term consequences.

The liquidity overhang is the cost of that intervention. Understanding its structure is the prerequisite for managing it.

The Carry Arithmetic: Why Banks Have an Incentive to Lend

Banks mobilised FCNR(B) deposits at rates of 6%-7.5%, well above the historical 3%-4% range, to attract NRI capital. The RBI absorbed the principal hedging cost through its concessional swap, but the interest cost on those deposits remains the banks’ obligation.

Banks are therefore paying 6%-7.5% on FCNR liabilities while earning only 5% on SDF balances, implying negative carry of 100-250 bps. Banks are unlikely to absorb that earnings drag indefinitely. The incentive is to move surplus funds into higher-yielding assets, including loans.

That incentive becomes more significant when excess reserves of this scale seek yield simultaneously. Credit demand is also strong: system credit growth stood at 19.3% year-on-year as of the fortnight ended July 15, 2026. This creates the possibility of a monetary impulse through faster credit expansion on top of an already difficult supply-side inflation environment.

The interest cost also extends to India’s external account. The RBI Governor disclosed on September 21, 2026 that 48.5% of deposits under the scheme are for five years, 42% for three to four years and 9% for four to five years.

At deposit rates of 6%-7.5% on $132.98 billion, the gross annual interest outgo would be roughly $8 billion-$10 billion. Against a return of around 4.14% on comparable US Treasury holdings, earnings on an equivalent amount would be about $5.5 billion. That implies a rough annual interest differential of $2.5 billion-$4.5 billion, although the RBI’s actual blended reserve return is not publicly disclosed.

The eventual cost could therefore be higher or lower depending on the maturity and composition of reserve assets. But the broader point remains: the external liability carries an interest cost that persists for the life of the deposits, irrespective of what happens to the rupee or oil prices.

The Sterilisation Cost Is Unavoidable, Only Allocable

The rupee liquidity released by the swap cannot simply be wished away.

As of September 11, 2026, approximately ₹6.82 trillion had been absorbed through VRRR operations, ₹4.05 trillion at around 5.24%, and the SDF, ₹2.77 trillion at 5%. That implies an annualised absorption cost of approximately ₹351 billion at those rates.

If ₹10-11 trillion were continuously absorbed at around 5%, the annual cost could rise towards ₹500 billion-550 billion. Ultimately, such costs reduce the RBI’s net income and, all else equal, the surplus available for transfer to the government.

The alternatives redistribute that burden rather than eliminate it. VRRR and SDF operations place the cost on the RBI balance sheet. MSS issuance makes the fiscal cost more explicit through additional government interest payments. An unremunerated CRR increase transfers more of the burden to banks because impounded reserves earn nothing.

OMO sales operate differently. They can withdraw durable liquidity by selling securities already held by the RBI, but they also reduce the RBI’s interest-earning asset holdings and can affect government bond yields through additional market supply.

The policy question, therefore, is not whether sterilisation has a cost. It is how that cost should be distributed and which instrument causes the least distortion.

The Case for a Remunerated Incremental CRR

Market analysts have discussed whether the RBI could use an incremental cash reserve ratio before resorting to a repo rate increase. The instrument was last deployed in August 2023. No such measure has been announced.

This article recommends considering an improved version: a remunerated I-CRR.

A conventional I-CRR is unremunerated. Banks must impound reserves while continuing to pay 6%-7.5% on FCNR liabilities. It also affects banks regardless of their individual exposure to the FCNR scheme.

A remunerated I-CRR at, say, 4%-4.25%, below the SDF rate, could absorb reserves while partially compensating banks for the carry disruption. It would cost the RBI less than absorption through the SDF and could tighten short-end liquidity without imposing the full cost of an unremunerated reserve requirement.

The RBI’s internal group on the Liquidity Adjustment Facility has previously discussed CRR remuneration being delinked from the Bank Rate and set below the repo rate. Whether such remuneration can be implemented under the current statutory framework should, however, be established before treating it as an immediately available instrument.

There is another complication. FCNR(B) deposits were exempted from CRR and SLR under Circular RBI/2026-27/99. An I-CRR applied to incremental system NDTL may not formally reverse that relief, but banks that priced FCNR deposits on the assumption of full exemption could still face changed economics.

Communication would therefore matter.

An exit rule should also be explicit. One possible threshold would be to unwind the measure once system credit growth remains below 12% annualised for two consecutive fortnightly RBI releases. That is the author’s proposed threshold, not an RBI trigger.

With credit growth currently at 19.3%, the argument for containment is stronger. The instrument should nevertheless remain temporary rather than becoming a permanent feature of the liquidity framework.

Why a Rate Hike May Still Be Required

A repo rate increase to 5.50% at the October 5-7 MPC meeting, which 35 of 61 economists in a September Reuters poll expect, would serve a different purpose.

It would not primarily be a liquidity-draining instrument. Banks holding large excess SDF balances have little need to borrow at the repo window, so a rate increase would not immediately raise their marginal funding cost.

Its role would instead be signalling.

CPI inflation was 4.82% in August 2026, the third consecutive month above the RBI’s 4% target. Food inflation was 5.95% and transport inflation exceeded 14%. A rate increase would signal that the central bank’s tolerance for sustained above-target inflation is limited.

The transmission caveat is important. A repo increase in a system awash with surplus liquidity could transmit imperfectly. That strengthens the case for addressing liquidity conditions either before or alongside a rate move.

In that sequencing, liquidity tools address the quantity of excess funds while the repo rate communicates the policy stance.

MSS and the Role of Government Securities

The next step is managing the durable portion of the surplus.

Under the Market Stabilisation Scheme, the government issues securities specifically to absorb liquidity. The proceeds are kept in a separate account with the RBI and cannot be used for normal government expenditure. The sterilisation cost therefore becomes visible through the government’s interest bill rather than remaining embedded primarily in the RBI’s balance sheet.

MSS issuance would still add securities to the market and could affect yields. Its advantage is not that it is costless or market-neutral, but that it provides a clearly identified mechanism for sterilising durable liquidity.

State Development Loans serve a different purpose.

State governments typically borrow at a spread over central government securities. Banks holding large surplus balances may find SDL yields more attractive than the 5% available through the SDF, encouraging some movement into longer-duration government assets rather than private credit.

That can influence the composition of bank balance-sheet deployment, but SDL purchases do not themselves permanently remove system liquidity. Primary issuance can temporarily transfer balances to government accounts, but government spending eventually returns those funds to the banking system.

SDLs should therefore be viewed as a portfolio-allocation channel rather than a substitute for sterilisation through instruments such as VRRR, CRR, MSS or OMO sales.

Three Geopolitical Scenarios

Three scenarios are plausible over the next three to six months, each with different implications for liquidity and inflation.

Scenario 1 — Ceasefire or diplomatic resolution. Oil retreats towards the Allianz Research baseline of $78 per barrel by year-end. Imported inflation eases, but the FCNR(B) deposits remain.

This could prove particularly challenging for domestic monetary management. The external justification for tight policy would weaken even though the liquidity surplus and banks’ carry incentives remained broadly unchanged.

Scenario 2 — Prolonged conflict. Oil remains above $100 through mid-2027. The liquidity surplus persists while inflation remains elevated. The World Bank projects energy prices 24% higher in 2026 than in 2025 and has warned that a sustained disruption could lift developing-economy inflation to 5.8%.

Under such conditions, the case for active sterilisation would strengthen.

Scenario 3 — Escalation. Brent approaches $115 if critical energy facilities suffer further damage. India would face a more pronounced imported stagflation shock.

In such a scenario, additional monetary tightening would require greater caution because higher rates would do little to address the source of supply-driven inflation while potentially weakening domestic demand. The RBI might instead need to prioritise liquidity management while assessing the persistence of the external shock.

The Structural Point

The liquidity surplus was created through the external sector, but it will not necessarily be resolved by an improvement in external conditions.

The FCNR(B) deposits have maturities of three to five years. They do not disappear if the rupee strengthens or oil prices fall. The associated domestic liquidity therefore requires active management independently of the original external shock.

That creates an important policy asymmetry.

If oil falls and imported inflation eases, pressure for monetary accommodation could increase even though the domestic liquidity overhang remains. If oil stays elevated, the case for tighter policy remains clearer, but imported inflation and excess liquidity become more difficult to manage simultaneously.

The sequencing should therefore focus on the nature of each instrument.

A temporary liquidity measure can contain the incentive for rapid credit expansion. The repo rate can communicate the RBI’s inflation stance. Durable sterilisation instruments such as MSS or OMO sales can address the structural component of the surplus.

These decisions should be taken before excess liquidity becomes embedded in broader credit and money creation.

The medium-term issue also remains. A large share of the FCNR(B) deposits will mature between 2029 and 2031. Managing today’s liquidity surplus will not eliminate those future foreign currency obligations.

The RBI will therefore need to prepare for the eventual repayment profile alongside its near-term sterilisation strategy. The challenge is not merely how to absorb today’s liquidity, but how to manage the full lifecycle of the intervention.