At the start of the year, there was an easy consensus in India’s financial circles. Interest rates were headed lower, liquidity would be ample, credit growth would revive, and government bond yields would drift down in an orderly fashion. It was a familiar script, and a reassuring one.

The Reserve Bank of India began the year with conviction. By early summer, the repo rate had been cut by 100 basis points. This was accompanied by substantial durable liquidity injections of close to ₹9.12 lakh crore — through bond purchases, foreign exchange swaps, and assured liquidity balance of 1 per cent of ‘net demand and time liabilities’ (NDTL) in the banking system. Additionally, to the markets’ delight, the central bank announced a cut in the cash reserve ratio from 4 per cent to 3 per cent, a level last seen during the pandemic. For banks, this was balance-sheet relief.

The intent was to lower the cost of funds, accelerate credit growth, and ease regulatory constraints in line with the banking system’s evolving structure.

Initially, the response was textbook. Money market rates softened, the benchmark 10-year bond yield fell below 6.2 per cent, and transmission to deposit and lending rates was materially faster than in previous easing cycles. Fresh rupee lending rates fell by 70 bps while fresh term-deposit rates were down by 87 bps in the first six months of 2025. But financial indicators rarely move in straight lines.

Liquidity conundrum

By the middle of the fiscal year, bond yields started bottoming out, the pace of transmission stalled, and liquidity balances reduced. In its June policy, the RBI shifted its stance from “accommodative” to “neutral”, indicating limited scope for further rate cuts. The demand at longer maturities thinned, and the familiar “end-of-cycle” trade emerged.

The yield curve steepened, and the premium between the repo rate and the 10-year government bond widened by over 100 bps by August — an outcome commonly seen when markets sense that the easing phase is largely behind us.

External developments left their impact too. Optimism around a favourable trade outcome with the US faded, creating its own headwinds. The imposition of 50 per cent tariffs triggered capital outflows of roughly $4 billion since June. The RBI intervened to curb currency volatility and signalled a strong defence against speculative attacks on the rupee. From a stability perspective, the strategy worked. The rupee behaved far better than many had anticipated and weakened less than 1 per cent between August and October-end.

But this is where policy entered a circular problem. Foreign exchange intervention, by design, absorbs rupee liquidity. By November, the cumulative impact of these operations had quietly undone a meaningful portion of the durable liquidity injected earlier in the year. As a result, system liquidity averages declined, and cost of borrowing inched up. The weighted average lending rate (WALR) in the banking system on fresh rupee loans rose by 14 bps in October, and CD (certificate of deposit) and CP (commercial paper) rates climbed above 6 per cent.

In the bond market, tightening liquidity, heightened risk aversion, and demand-supply mismatch pushed yields higher, despite record-low inflation and the RBI’s dovish guidance in the October policy.

Competing goals

In effect, the RBI found itself balancing two competing objectives. Supporting domestic liquidity and transmission required sustained injections. Managing the rupee amid volatile capital flows led to absorbing that very liquidity. Each action partially offset the other.

December brought another rate cut of 25 bps and additional durable liquidity — nearly ₹1.5 lakh crore through open market operations and FX swaps. Yet, funding conditions remain tight and cost of funds stays stubbornly elevated for banks and borrowers alike.

Looking ahead to early 2026, the constraints could persist. Seasonal factors — more currency in circulation, slower government spending, and steady credit growth — could weigh on liquidity. On top of this, the RBI’s forward foreign exchange book — close to $63 billion as of October — continues to mature. As these positions unwind, they create an additional, mechanical drain on rupee liquidity unless actively offset. The central bank may need to further inject durable liquidity of nearly ₹1.5-2 lakh crore, or even more if the intervention on the FX side continues at the current pace.

This is the heart of the challenge. The RBI is managing a narrow corridor between domestic transmission and external stability. Rate cuts alone cannot widen that corridor. Nor can repeated liquidity injections fully succeed if they are persistently neutralised by currency defence. At some point, a choice becomes unavoidable. Allowing the rupee to adjust modestly — rather than resisting every bout of pressure — may offer a way out of the loop.

Looming trade-off

Central banking rests on the management of trade-offs. In this cycle, the trade-off is clear: between defending the rupee and easing the monetary policy for the real economy. Navigating that balance will define the next phase of policy — and determine whether rate cuts finally deliver what they promise.

(The writer is Principal Economist, HDFC Bank)

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Published on December 22, 2025