The probability of an interest rate hike, which would be the first in the current cycle, at the upcoming monetary policy meeting scheduled for October 5–7 has increased after the Reserve Bank of India (RBI) announced the conduct of a 30-day Variable Rate Repo Reverse Repo (VRRR) auction for a notified amount of 7 trillion rupees on Monday.
Liquidity surplus in the banking system reached a new record of 10.3 trillion rupees on Thursday, surpassing the previous high of 9.7 trillion rupees recorded on Wednesday. Against the backdrop of an inflow of over $136 billion through the RBI's preferential currency swap, India's foreign exchange reserves grew to a record $740.8 billion in the week ending August 28. The rupee strengthened by 0.94 percent against the US dollar during this week and by 1.3 percent since June 8, when the swap schemes were introduced.
The accumulation of reserves was driven by Foreign Currency Assets (FCA), which constitute the largest part of the reserves and increased by almost $60 billion over the last nine weeks, reaching $601 billion. Overall, reserves grew by $73.9 billion over this nine-week period, significantly exceeding the previous record of $729.3 billion reported a week earlier. This growth is the strongest since April-June 2021, when reserves grew for 10 consecutive weeks, although the increase was smaller then—$31.2 billion.
According to experts, faced with excess liquidity, the RBI faces a delicate choice: either absorb the surplus cash without exerting additional pressure on financial markets or use interest rates to combat ongoing tension in the rupee and bond markets. Dealers noted that the VRRR auction on Monday, especially its early repayment provision, should ease concerns about further liquidity tightening measures before the October policy meeting.
The central bank improved the auction conditions by allowing banks to prepay funds they had placed—a first for such an auction. When announcing the auction, the RBI stated: 'Requests for early repayment can be submitted no less than two working days prior to the original maturity date.'
This move is expected to provide relief to the bond market, which was bracing for further liquidity tightening measures, according to dealers. A treasury head from a private bank stated: 'It means no new measures until the policy. The rupee remained under pressure, bond yields remained high, and liquidity in the banking system was skewed; thus, a rate hike now seems the most preferred tool for the RBI.'
The possibility of a rate hike emerged for the first time after the publication of the Monetary Policy Committee meeting minutes in August, where members pointed to inflation risks becoming widespread due to high demand.
Market participants believe the early repayment option may also encourage banks to place funds for the full 30-day term more willingly. Lenders were previously reluctant to lock in liquidity for longer periods due to the expected outflow of tax revenues at the end of the month.
A primary dealer center dealer noted: 'With the option to request early repayment if liquidity is needed, banks may feel more comfortable placing funds for the full term, supporting demand.'
Another dealer at a public bank reported that the partial repayment option should ease the situation in the market, as it indicates a possible absence of further liquidity measures before the Monetary Policy Committee meeting in October. This dealer added that the yield on the benchmark 10-year government bond could open 2-3 basis points lower.
The record reserves are largely a result of the mobilization of non-resident deposits in foreign currency (bank) — FCNR(B), under which banks attracted $127.2 billion through a preferential swap scheme. Although the window for attracting deposits closed on August 31, banks can utilize the swap scheme for already concluded contracts with the central bank until September 11.
This means that the reserve accumulation is not yet complete. Economists predict that additional inflows will increase FCA—expressed in dollars and including the effect of growth or decline of non-dollar currencies such as the euro, pound sterling, and yen held in reserves—to approximately $640–$650 in the coming weeks.
Madan Sabnavis, chief economist at Bank of Baroda, stated: 'Foreign currency assets should grow from here, as the inflow will arrive before September 11. We should receive at least $100–$110 in total, bringing the total amount to approximately $640–$650 FCA.'
The period for FCNR(B) deposits closed on August 31, while External Commercial Borrowings (ECB) and Overseas Foreign Borrowings (OFCB) remain available under this program until December 31, 2026.