Why OMOs Matter in This MPC

India enters this Monetary Policy Committee meeting with a striking contradiction. Real GDP growth remains impressive on paper, yet the monetary system that supports the real economy is facing one of its most challenging quarters in years.

The combination of unsterilised foreign exchange intervention, heavy forward-book maturities and seasonal currency demand has pushed liquidity into a narrow zone where even routine swings in government balances can unsettle the overnight funds market.

The focus has been on the timing of rate cuts, but the more material question is how the Reserve Bank intends to replenish durable liquidity over the next three months. The answer will define whether transmission improves or tightens further, and it will shape the trajectory of bond yields as the financial year approaches a supply-intensive quarter.

The squeeze has developed rapidly.

Liquidity that sat comfortably above 1% of NDTL through the middle of the year has slipped below 0.5% in recent months. The decline reflects structural pressures. The central bank has sold an estimated $22 billion to $25 billion in the spot market since September to stabilise the rupee, which has withdrawn an equivalent amount of rupee liquidity on a permanent basis.

That alone has offset the liquidity added earlier through CRR cuts and the ₹2.4 trillion of OMOs conducted in the first quarter. Currency in circulation has continued to leak out of the system at a pace in line with the ten-year average, rather than easing, and higher year-end government spending has not been enough to counter the drag created by FX operations.

The forward book adds another layer of complexity. About $37 billion of buy–sell forward contracts are due to mature over the next three months. Even if the RBI takes delivery of only a part of this amount, the rupee liquidity absorbed could reach roughly ₹1 trillion.

The balance of payments backdrop offers little relief. The BoP is likely to remain in deficit, which, alongside patchy FPI flows and a wider trade gap, will keep the Reserve Bank active in the FX market, which keeps the bias on liquidity tight rather than neutral.

Currency in circulation also rises seasonally between January and March, and the expected outflow of ₹770 billion will further pull durable liquidity lower at exactly the point when credit demand rises.

If left unaddressed, system liquidity could fall to about 0.2% of NDTL by March. That would be uncomfortably low even in a neutral policy environment. It would be particularly problematic in a period where inflation is already well contained, and policy transmission is meant to guide lending conditions into a more accommodative zone.

Reserve Money
Past easing cycles have all ended with liquidity comfortably above 1% of NDTL, which helps explain why rate cuts at the tail end of a cycle tend to work better when accompanied by balance-sheet expansion. The current cycle has not enjoyed that support. Reserve money growth has slowed to near zero, the central bank’s balance sheet has expanded by only about 4.4% so far this year, and the heavy FX intervention since September has offset a significant portion of the earlier OMO infusion.

A liquidity shortage at this point carries wider implications.

Credit growth has held up at around 12%, while deposit growth is nearer 10%, which has pushed the credit-deposit ratio above 80%. Banks will need a more stable flow of reserves to support loan growth into the final quarter of the year. Without that, they will have to bid more aggressively for deposits, which raises funding costs and dilutes the impact of any policy easing.

The sovereign bond market also faces a heavy calendar. State borrowing will cross ₹5 trillion in the January–March quarter, and term premia remain elevated across the curve. Liquidity that is too tight tends to steepen the curve even further, which complicates government financing and restrains private investment.

For these reasons, the case for front-loaded OMOs is stronger than the case for an immediate rate cut. OMOs inject durable liquidity directly into the banking system, reduce the need for banks to pay up for deposits, anchor term premia and distribute the financing load more evenly across the curve just as state borrowing peaks. They also stabilise the monetary base at a time when the Reserve Bank’s forward operations threaten to drain reserves more quickly than the system can absorb.

The discussion on the repo path will continue, and inflation remains low enough to support a gradual easing bias over the next two quarters. Yet the effectiveness of that easing depends almost entirely on whether liquidity conditions remain supportive. A clear OMO programme of about ₹2 trillion between now and March would help restore the balance between the real and nominal sides of the economy and create the conditions for more durable transmission.

In a cycle where the headlines flatter to deceive, the liquidity stance, even more than the repo rate action, will do the heavy lifting.