At the start of 2025, the story looked clean: rate cuts would do their job, liquidity would stay comfortable, credit growth would regain pace, and bond yields would glide lower. The RBI delivered the script — a cumulative 100 bps repo cut by early summer, sizeable durable liquidity injections, a 1% assured liquidity balance, and a CRR cut that gave banks immediate balance-sheet breathing space. Markets responded exactly as textbooks promise. Then the plumbing intervened. FX intervention — necessary in volatile flows — began absorbing rupees and quietly reversing part of the earlier liquidity comfort. The consequence is what the article calls a “liquidity loop”: policy pushes liquidity into the system with one hand, and pulls it out with the other. When this loop persists, rate cuts lose power, and the economy feels tight even when inflation is low.
What’s in the news
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The RBI cut the repo rate aggressively in 2025 and injected durable liquidity through bond purchases, FX swaps, and an assured liquidity balance linked to NDTL.
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Liquidity conditions eased early in the year, helping faster transmission to deposit and lending rates and lowering bond yields.
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But FX intervention absorbed rupee liquidity, tightening system liquidity by mid-year and pushing up funding costs (CD/CP rates and fresh loan WALR ticked higher).
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Even after another 25 bps cut and fresh durable liquidity operations in December, funding conditions remain relatively tight.
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Looking into early 2026, seasonal currency demand, government cash balances, ongoing credit growth, and the RBI’s forward FX book maturities may keep liquidity under pressure unless actively offset.
The “liquidity loop” in simple terms
Think of liquidity as the banking system’s working fuel.
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When RBI injects durable liquidity (OMOs, long-duration repos, FX swaps that add rupees), banks have more fuel. Money-market rates soften, bond yields ease, and loan pricing transmits faster.
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When RBI intervenes in FX markets to manage rupee volatility, it often absorbs rupees (or sterilises liquidity), reducing that fuel.
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If both happen persistently, the system enters a loop where the net liquidity outcome becomes unstable, and funding costs can remain sticky even after rate cuts.
This is not a policy mistake; it is a policy tension. India is simultaneously managing:
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domestic transmission and growth support, and
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external stability amid volatile flows.
But when these objectives collide in the same liquidity channel, the “loop” forms.
Why it matters
1) Rate cuts don’t transmit cleanly without stable liquidity
A rate cut is a signal. Liquidity is the medium through which the signal becomes reality. If liquidity tightens, banks protect margins, deposit rates resist falling, and lending rates stop easing.
2) Tight liquidity raises the economy’s true cost of capital
Even if the policy rate is lower, CP/CD rates moving up, and WALR creeping higher, tell borrowers the real marginal cost of money has firmed. That can slow capex and discretionary credit demand.
3) Bond yields stop reflecting the macro story
When liquidity is tight, yields can rise despite low inflation because market participants price funding stress, risk aversion, and demand-supply mismatch — not just inflation expectations.
4) The credibility test shifts from “policy stance” to “policy execution”
Markets increasingly watch the RBI’s liquidity corridor management, not just the repo rate.
What it would take to “exit the loop”
Exiting the loop doesn’t necessarily mean choosing growth over the rupee or vice versa. It means aligning the instruments so one objective doesn’t repeatedly cancel the other.
1) Commit to a clearer liquidity corridor — and defend it
The RBI can aim for a stable, predictable system liquidity range (not just an occasional comfort injection). When markets know the corridor is defended, volatility in short-term rates reduces and transmission improves.
Practical Indian constraint: A rigid corridor is hard in a large economy with heavy government cash flows and seasonal currency demand.
Workable approach: A flexible corridor with transparent “triggers” for action (e.g., if money-market rates persistently deviate from the policy corridor).2) Prefer “durable” liquidity tools over repeated stop-gap injections
When liquidity drains are structural (FX interventions, forward maturities, cash leakage), short-term fixes don’t last. Durable liquidity is created through:
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sustained OMOs in government securities,
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longer-tenor repos,
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and carefully designed FX swap operations that don’t leave a messy maturity wall later.
Key idea: Avoid a cycle where you inject today and scramble to reinject when today’s tools mature.
3) Smooth the FX forward maturity profile to reduce mechanical drains
A large forward book can create periodic liquidity drains as positions unwind. The solution is not to stop using forwards, but to:
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stagger maturities,
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reduce bunching,
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and proactively offset predictable drains.
Practical challenge: FX markets can become one-way in stress episodes; smoothing must respect market depth.
4) Improve coordination with government cash management
Government balances can tighten liquidity sharply when spending slows or cash is parked. Better predictability in cash balances and expenditure timing helps the RBI avoid overcorrecting.
Practical Indian reality: Fiscal operations are not designed around liquidity stability.
Workable improvement: Better transparency and scheduling coordination, especially around quarter-ends and large outflows/inflows.5) Strengthen the deposit channel so banks aren’t structurally “funding-stressed”
Even with liquidity support, if deposit growth lags credit growth, banks will keep competing for deposits, keeping funding costs elevated. This is why the loop feels stubborn: part of the problem is structural funding, not just RBI liquidity.
Practical implication: Monetary easing will transmit faster when bank funding is not perpetually tight.
The trade-off India must manage — honestly
India cannot treat FX stability and domestic transmission as separable silos. In a world of volatile flows, the RBI will sometimes have to absorb liquidity to manage disorderly rupee moves. The real question is how quickly and cleanly it can replenish liquidity in a durable way, without creating future maturity cliffs.
If the RBI chooses to keep intervening actively in FX markets, then a parallel, explicit plan for durable rupee liquidity replenishment becomes essential — otherwise rate cuts look generous on paper but feel ineffective in practice.
Way ahead
A credible exit from the liquidity loop would look like:
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a stable liquidity corridor that keeps money-market rates anchored,
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durable injections sized to offset structural drains (including forward maturities),
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better maturity management of FX tools,
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tighter coordination on government cash flows,
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and attention to the bank funding structure so deposit stress doesn’t keep the cost of capital sticky.
Ultimately, the RBI’s challenge is not choosing between domestic and external stability. It is ensuring that the plumbing doesn’t keep neutralising the signal — and that the real economy finally feels the easing that the policy rate already announces.
Source credits : The Hindu; RBI policy communications and liquidity operations as referenced in the reported piece; market indicators and rate transmission data discussed in the article.
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