Durable liquidity, sterilisation and currency shocks

Detail

1. Basic terms: liquidity, LAF and "durable" liquidity

• Liquidity here means the spare cash that banks hold with the RBI after meeting their reserve rules. When banks have more spare cash, it is cheaper for them to lend.
• LAF (Liquidity Adjustment Facility) is the RBI's daily window for managing this cash.
• Through the repo, the RBI lends to banks for a short time against government bonds.
• Through the reverse repo or SDF, the RBI takes surplus cash from banks.

• LAF deals usually last from one day to a few days. They handle frictional liquidity, which means short, day-to-day swings.

• Durable liquidity is money that stays in the banking system (or stays out of it) for months or years. The RBI changes it when a gap looks like it will last, not just for a day.

• Rule of thumb:
• A short-term problem → the RBI uses LAF.
• A lasting surplus or shortage → the RBI uses the durable tools in section 2.

2. Durable tools beyond daily LAF

(a) Open Market Operations (OMO)

• OMO means the RBI buys or sells government securities (G-secs) in the open market.
• OMO purchase: the RBI buys bonds and pays banks in rupees. This injects durable liquidity.
• OMO sale: the RBI sells bonds and banks pay it rupees. This absorbs durable liquidity.
• Recent use:
• The RBI injected ₹2.39 lakh crore of durable liquidity through OMO purchases in April–May 2025 [2].
• It added further OMO purchases of ₹1 lakh crore in December 2025 [2].

(b) Cash Reserve Ratio (CRR) changes

• CRR is the share of a bank's NDTL (Net Demand and Time Liabilities, which is mainly deposits) that the bank must keep as cash with the RBI. The RBI pays no interest on this cash.
• Money multiplier (NCERT, simple form): money multiplier = 1 / reserve ratio.
• At a CRR of 4%, the multiplier is 1 / 0.04 = 25.
• At a CRR of 3%, the multiplier is 1 / 0.03 ≈ 33.3.

• A lower CRR means each rupee of reserves can support more deposits and loans.

• Worked example (illustrative numbers):

• A bank has NDTL of ₹10,000 crore.
• At a 4% CRR it must keep ₹400 crore with the RBI. At a 3% CRR it must keep ₹300 crore.

• So ₹100 crore is released and can be lent. This is a durable injection because it stays in the system until the CRR is raised again.

• Timeline:

• December 2024: CRR cut from 4.5% to 4%.

• 2025: CRR cut by 100 basis points to 3.0% during September–November 2025, in tranches [2]. (NCERT scaffold: "cut to 3% in tranches".)

• Effect: after the liquidity injections, system liquidity stayed in surplus [2].

• It averaged ₹1.89 lakh crore in FY26 (up to 8 January 2026), against only ₹1,605 crore in FY25 [2].
• Broad money (M3) growth rose to 12.1%, from 9% a year earlier. This showed that banks were using the cash released by the CRR cut [2].

(c) Long-Term Repo Operations (LTRO)

• LTRO was started in February 2020. Under it, the RBI lends to banks for 1 to 3 years at the repo rate, against G-secs.
• Why it matters:
• Banks get cheap funds that stay fixed for a long period.

• So they can lower their loan rates, which improves monetary transmission (a repo rate change actually reaching borrowers).

• Targeted LTRO (TLTRO) (2020) and on-tap TLTRO (available at any time, not only on auction dates) came with a condition. Banks had to use the money in specified or stressed sectors, such as corporate bonds or small businesses during COVID-19.

(d) Forex swap auction

• A buy/sell swap has two legs.
• Near leg: the RBI buys dollars from banks now and pays them rupees. Rupees are injected.
• Far leg: after the agreed period, the RBI sells the same dollars back at a rate fixed in advance.

• So rupees stay in the system for the whole swap period. The RBI's forex reserves are only borrowed, not spent.

• Episodes:

• March 2019: $5 bn for 3 years. This was the first large durable-liquidity swap.
• February 2025: $10 bn for 3 years (NCERT scaffold figure; no official source retrieved to confirm the amount).

• December 2025: another 3-year USD/INR buy/sell swap of $5 bn [2].

• Worked example (illustrative rate of ₹85/$):

• $5 bn × ₹85 = ₹42,500 crore of rupees injected for 3 years.

• Opposite tool: sell/buy swap.

• Here the RBI sells dollars on the near leg and takes rupees from banks' current accounts.
• This eases a dollar shortage and absorbs rupees.

• Example: in March 2020 the RBI held a 6-month $2 bn sell/buy swap during the COVID-19 "flight to safety". Only Category-I Authorised Dealer banks could bid, and the first leg was settled at the FBIL reference rate [5].

• Trap: a buy/sell swap injects rupees. A sell/buy swap absorbs rupees.

3. Sterilisation

Meaning

• Sterilisation means protecting the domestic money supply from external shocks, such as large forex inflows or outflows.
• Class 12, Money and Banking: the RBI "sterilises the money supply … against external shocks".

How it works: the two-step move

• Step 1: foreign capital flows in, and the RBI buys dollars to stop the rupee rising too much. This adds rupees to the system.
• Step 2: the RBI sells bonds through OMO or MSS. This takes those rupees back out.
• Net result: forex reserves go up, but the money supply stays roughly the same. So there is no extra push to inflation.

Worked example

• Inflow of $2 bn at ₹85/$ → the RBI buys the dollars → +₹17,000 crore reaches banks.
• The RBI sells ₹17,000 crore of securities → banks pay → −₹17,000 crore.
• The change in reserve money from this inflow is roughly zero.

Market Stabilisation Scheme (MSS)

• The MSS is based on a Memorandum of Understanding (MoU) signed in 2004 between the Government of India and the RBI. The scheme took effect in April 2004 [3].
• It was started to strengthen the RBI's ability to keep the forex market stable and to run monetary policy [3].
• Mechanics:
• The Government of India issues T-bills and dated securities to soak up surplus liquidity.
• The money raised is kept in a separate account and not spent, so it cannot come back into the system as government spending.

• The budget pays the interest cost. This is the fiscal cost of sterilisation.

• Ceiling: the upper limit on MSS securities is agreed between the Government and the RBI through the MoU from time to time [3].

• Why MSS was needed:
• In 2003–04, heavy dollar buying was using up the RBI's own stock of G-secs available for OMO sales.
• MSS gave the RBI extra, government-issued bonds to sterilise with.

Incremental Cash Reserve Ratio (ICRR)

• ICRR is a temporary extra CRR. It applies only to the increase in NDTL during a chosen period. It is used to absorb a sudden surplus of liquidity.
• Worked example:
• A bank's NDTL rises by ₹1,000 crore during the chosen window.
• Under a 100% ICRR, it must park all ₹1,000 crore with the RBI.

• Under a 10% ICRR, it must park ₹100 crore.

• Link: the impossible trinity is covered in the balance-of-payments and exchange-rate note.

• The impossible trinity means a country cannot have all three of these at once: a fixed exchange rate, free capital flows, and its own independent monetary policy.
• Sterilisation is how the RBI tries to manage the pressure between these three goals.

4. Case: Demonetisation, November 2016

Meaning and scale

• Demonetisation means withdrawing legal tender status from currency notes. Legal tender is money that must legally be accepted to pay a debt.
• In November 2016, ₹15.41 lakh crore of old ₹500 and ₹1,000 notes lost legal tender status. This was about 86% of currency in circulation.
• About 99.3% of it came back into banks as deposits.

Why it was a liquidity shock

• Deposits surged and banks were flooded with cash:
• People deposited old notes → bank deposits and NDTL jumped.

• Banks had huge surplus funds but few borrowers → the surplus went to the RBI.

• The RBI's absorption steps:

• Reverse repo: the RBI absorbed surplus funds every day.
• 100% ICRR: applied to NDTL added between 16 September and 11 November 2016. It was imposed on 26 November and withdrawn on 10 December 2016.
  • The ICRR drained about ₹4,000 billion (₹4 lakh crore) in the fortnight ended 9 December 2016 [4].
  • It was withdrawn from the fortnight beginning 10 December 2016 [4].

• MSS ceiling raised to ₹6 lakh crore. Once MSS bills were available, the RBI could release the ICRR cash.

• Remonetisation, which means putting new notes back into circulation, went on through 2017.

The debate

• Benefits claimed in Class 12, Box 3.2:
• Savings moved into the formal system.
• Banks got more resources.
• Lending rates fell.

• Tax compliance improved.

• Criticism (Economic Survey 2016-17):

• There was a cash crunch.
• The informal (cash-based) sector suffered losses.

5. Case: ₹2,000 note withdrawal, May 2023

• The ₹2,000 notes were withdrawn from circulation, but they stayed legal tender. This is a key difference from 2016.
• Returned notes pushed up deposits. The RBI imposed a 10% ICRR on NDTL added between 19 May and 28 July 2023.
• The ICRR was unwound by October 2023.
• Links: the history of legal tender is covered in the money-evolution-functions note. The digital payments push is covered in the payment-systems-digital-finance note.

Prelims Hooks

• Buy/sell forex swap: the RBI buys dollars now, which injects rupees. Sell/buy swap: the RBI sells dollars now, which absorbs rupees. Example: the March 2020 $2 bn 6-month sell/buy swap [5].
• MSS: based on a 2004 GoI–RBI MoU. The securities are issued by the Government, the money raised is not spent, and the budget pays the interest [3].
• ICRR applies only to the increase in NDTL over a set period, not to all deposits. Examples: 100% (Nov–Dec 2016) and 10% (May–Oct 2023).
• CRR was cut by 100 bps to 3.0% in September–November 2025 [2]. Before that it was cut from 4.5% to 4% in December 2024.
• LTRO (February 2020): 1–3 year funds at the repo rate, not at the MSF rate or bank rate.
• Money multiplier = 1 / reserve ratio. A CRR cut from 4% to 3% raises it from 25 to about 33.3.
• Demonetisation 2016: ₹15.41 lakh crore (about 86% of currency) was demonetised, and about 99.3% came back to banks.
• Trap: in 2023 the ₹2,000 note was withdrawn but remained legal tender. In 2016 the old ₹500 and ₹1,000 notes lost legal tender status.
• Sterilised intervention leaves reserve money roughly unchanged, while forex reserves rise.

Mains Points

• Sterilisation has a cost for the budget:
• MSS interest is paid from the budget.
• Low-return dollar reserves are funded by high-interest rupee bonds, which creates a "carry cost".
• So large capital inflows force a choice between inflation (not sterilising) and a fiscal burden (sterilising).

• This is the practical face of the impossible trinity.

• Choice of tool shapes transmission:

• CRR cuts and OMO purchases release funds for good, so they cut banks' cost of funds more steadily than overnight LAF money.
• The FY26 CRR and OMO injections lifted M3 growth to 12.1% [2].

• But a surplus that lasts too long can push inflation up and weaken the rupee.

• Currency shocks as tests of liquidity management:

• In 2016, the RBI used ICRR as a quick fix until the MSS limit was raised to ₹6 lakh crore. The ICRR drained about ₹4 lakh crore in one fortnight [4].

• Lesson for policy design: formal pre-agreed tools such as the SDF and the MSS, with room to scale up, are better than stop-gap measures.

• Demonetisation trade-off (GS-III):

• Gains: more formal saving, a larger tax base and a push to digital payments.
• Costs: a cash crunch, losses in the informal sector and output losses (Economic Survey 2016-17).
• The ≈99.3% return of notes undercut the argument that it would destroy black money held as cash.