Surplus liquidity won't spur credit growth despite RBI's easing measures, says J.P. Morgan

Their analysis finds that excess liquidity primarily affects overnight borrowing costs but doesn’t translate into increased credit or deposit growth in the broader economy.

Liquidity drives overnight rates, not credit or deposits

“The role of liquidity in boosting monetary policy transmission occurs primarily through influencing overnight market rates, within the policy corridor,” economists Toshi Jain, Sajjid Z Chinoy and Divyanit Sood wrote in the July 4 report.

“There is no evidence of a ‘credit channel’ on deposit and lending growth beyond this,” they added.

RBI’s rate cuts yet to deliver credit revival

Since December, the Reserve Bank of India (RBI) has implemented aggressive rate cuts and injected liquidity into the banking system to revive a slowing economy amid benign inflation. The Central bank has expressed hope that this combination would lower borrowing costs and spur demand.

However, bank credit growth remained sluggish, falling below 10% in May, raising questions about the effectiveness of liquidity-driven transmission.

Economists urge RBI to focus on rate alignment

The economists noted that the RBI should aim to manage liquidity just enough to maintain overnight rates in line with the policy repo rate. Injecting or withdrawing liquidity beyond this, they argue, has no standalone impact on credit growth.

“A large surplus of liquidity in the Indian market pushed overnight rates down to below the policy repo rate in recent months and, in some cases, even below the floor of the interest rate corridor,” the report observed.

RBI steps in to stabilise short-term rates

On Friday, the central bank withdrew ₹1 trillion ($11.7 billion) via a seven-day variable rate reverse repo auction to prevent overnight rates from falling too far below the policy rate. This operation rolled over a similar action taken last week.

India’s current policy repo rate stands at 5.50%, with the standing deposit facility (SDF) rate, the lower bound of the interest rate corridor, at 5.25%.

“Pushing up the overnight rate will constitute a tightening of monetary policy at a delicate time. Yet, eventually, the sanctity of the operating target will need to be adhered to,” the J.P. Morgan economists cautioned.