Five reasons why liquidity crunch will endure, hurting India’s growth

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Grim liquidity scene

Despite a series of countermeasures by the RBI since then, systemic liquidity remains negative and grim. The central bank's latest statement of March 28 says the “net liquidity injected” was negative at (-) Rs1.79 lakh-crore.

This came days after the RBI conducted a mega auction (buying US dollars) on March 24, of $10 billion dollar-rupee buy-sell swaps, to release liquidity. Besides, since January, the RBI has been carrying out open market operations (OMO), and daily variable rate repo (VRR) auctions, among others.

Soon, the liquidity crunch may ease and the brouhaha over it forgotten but some of the underlying factors would persist. These are beyond the RBI’s remit to remedy and require policy interventions by the Centre.

Before flagging them, here is a brief background.

Eye on inflation

Truth be told, both Chief Economic Advisor Anantha V Nageswaran, in September 2024, and Commerce and Industry Minister Piyush Goyal, in November 2024, asked the RBI to lower the interest rate to infuse more liquidity to boost investment/growth.

But former RBI Governor Shaktikanta Das resisted it as he waited for inflation to ease to 4 per cent. During the December 2024 Monetary Policy Committee (MPC) meeting, the Das-led RBI cut the cash reserve ratio (CRR) by 50 basis points (which had gone up since April 2022) to tame inflation, but not the interest rate (repo).

The new RBI Governor, Sanjay Malhotra, cut the repo by 25 basis points in February 2025. More is likely next month.

Also read: Why decline in bank deposit growth calls for serious attention

The RBI’s February and March bulletins listed four reasons for the liquidity crunch (“drainage of liquidity”), as did SBI Research: (a) advance tax payments (b) capital outflows (by foreign portfolio investors, or FPIs) (c) forex operations to check rupee depreciation and (d) a significant jump in currency in circulation (currency leakage).

Maha Kumbh angle

Advance tax payment burden would ease, FPIs may return, but there is no knowing how long the RBI would keep defending the rupee’s depreciation (by selling USD).

The economic rationale for this has been questioned by former CEA Arvind Subramanian and other economists for its many adverse impacts like tightening liquidity, hurting exports, causing loss of forex reserve, inviting speculative activities, etc.

The fourth one, “currency leakage” or large cash withdrawals (by individuals and small businesses) needs more attention because these are direct outcomes of economic policies. The RBI skipped explaining the leakage, but SBI Research attributed it to “inadvertent cash leakage because of Maha Kumbh” and warned that “a significant part of the money may not come back to systemic deposits”.

At best, this is a partial explanation. A closer scrutiny would show that currency leakage is much more than that. There are five primary reasons for it.

1. Slowdown in reserve money

First, the RBI has drastically slowed down money supply – supply of ‘reserve money’ – apparently, to tame inflation. 'Reserve money' refers to currency in circulation (CiC) – bankers’ deposits with the RBI and other deposits with the RBI.

RBI reports show a sharp slowdown in reserve money to 3.7 per cent in FY25 from 6.6 per cent and 9.7 per cent, respectively, in FY24 and FY23. It grew at an average of 12.8 per cent during FY14-FY22, barring the unusual spikes in FY17 and FY18 due to demonetisation.

CiC (75.1 per cent of reserve money) growth improved to 5.5 per cent in FY25 – from 4.1 per cent in FY24 – but it was way down from 7.8 per cent in FY23.

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The RBI attributed this fall (reserve money and CiC) to “withdrawal of Rs 2,000 banknotes”. But recall the RBI’s justification for withdrawing it on May 19, 2023. It had said, among other things, that “the stock of banknotes in other denominations continues to be adequate to meet the currency requirement of the public”. Now it realises that isn’t the case, despite a rise in digital transactions.

2. Growing informal economy

Second, the informal sector, which is cash-driven, and thus sucks out liquidity, is growing, too. Last assessed in FY14, it was “nearly half” of GDP.

There are three indicators that its share is growing:

• The Periodic Labour Force Survey (PLFS) report shows that the number of workers in informal agriculture went up from 44.1 per cent in 2017-18 to 46.1 per cent in 2023-24, “proprietary and partnerships firms” of households (informal sector) from 68.2 per cent to 73.2 per cent and “self-employed” from 52.2 per cent to 58.4 per cent during the same period.
• India Inc, though “swimming in excessive profits” – per Economic Survey 2023-24 – is witnessing “creeping informalisation” of workforce.
• The Annual Survey of Unincorporated Sector Enterprises (ASUSE) shows that informal sector establishments and workers grew 22.9 per cent and 23.2 per cent, respectively, between FY22 and FY24.

3. Inverted credit outflows

Third, credit growth is being driven by personal loans, including distress mortgaging of gold by households and small businesses, since the COVID pandemic.

RBI data shows that personal loans overtook credit outflows to services in FY20 and industry in FY21. The trend continued up to January 2025.

Since personal loans are for consumption and involve large cash withdrawals, as against credits to industry and services to produce goods and services, and transactions are through the banking system, this inversion is bad for economic growth, too.

Also read: Why declining inflation augurs well for India’s economic growth

4. Deposit-credit gap

Fourth, the gap between bank deposits and credits has persisted for several years, according to the RBI. Finance Minister Nirmala Sitharaman told bankers twice last year — in August and November — to focus on “core banking”, that is, mobilise deposits, not insurance or mutual funds.

The Securities and Exchange Board of India (SEBI) had exposed this tendency in the Yes Bank bankruptcy case in 2021. The bank was found to be diverting secured FDs to high-risk AT1 bonds.

Households are increasingly turning to the stock market (rising to 20 per cent) to benefit from the boom, as ‘real’ bank rates remain zero or negative. Both the RBI and SEBI expressed their concerns in 2024 about this shift in household behaviour on “structural liquidity” and “capital formation”.

5. Writing off corporate loan defaults

Fifth, a Lok Sabha answer of March 17, 2025, said that scheduled commercial banks wrote off Rs 16.35 lakh-crore of corporate loan defaults (non-performing assets, or NPAs) in the 10 fiscal years of FY15-FY24. Of this, Rs 3.86 lakh-crore was in FY23 and FY24 alone.

NPAs lock up bank capital (provisioning against it) and NPA write-offs cause permanent loss of capital since “recovery” during the same period is a mere 16 per cent (according to the RBI’s RTI reply of January 9, 2025).

Also read: ATM withdrawals set to become costlier from May 1 as RBI allows banks to hike charges

The above five factors go beyond the RBI’s remit and require the Centre’s policy interventions to be arrested or reversed.

Those changes should:

a) Increase money supply and raise demand for credit/investment in the production of goods and services, rather than for consumption

b) Formalise the economy to reduce massive cash withdrawals

c) Encourage households to keep their savings in banks by making deposit interest rates lucrative

d) Discourage corporate loan defaults and yearly NPA write-offs as a routine exercise.

Until that happens, “currency leakages” will remain a big threat – apart from depriving the economy of growth impetus, that is, investment in the production of goods and services.