India Faces Liquidity Crunch Despite Central Bank Rate Cuts

India's Short-Term Interest Rates Remain Unaffected by RBI's Rate Cuts

Key Figures:

• Repo rate: 5.25%
• One-year CD rates: 6.90% (recent high: 7.15%)
• Current account deficit (FY25): USD 23 billion
• Current account deficit (1H FY26): USD 15 billion
• Government cash balances with RBI: ₹3.3 trillion
• Currency in circulation: ₹40 trillion (up 10% year-on-year)

Despite the Reserve Bank of India's (RBI) efforts to cut the repo rate and maintain ample liquidity, short-term borrowing costs in India have failed to decrease. In fact, one-year certificate of deposit (CD) rates for leading banks have risen to 6.90%, a recent high of 7.15%, up nearly 35-40 basis points over the past three months.

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The root cause of this anomaly lies in the fact that credit growth continues to outpace deposit growth, tightening funding conditions despite RBI liquidity support. This is largely due to India's status as a current account deficit economy, with a deficit of USD 23 billion in FY25 and USD 15 billion in the first half of FY26. The delay in India's inclusion in the Bloomberg Global Aggregate Bond Index has further reduced foreign capital inflows.

Digital Payments Surge, Yet Cash Usage Rises

Interestingly, even as digital payments surge, currency in circulation has risen sharply to ₹40 trillion, higher by more than 10% year-on-year. This paradoxical trend is draining liquidity from banks, as physical cash circulates at a slower pace.

Government Spending and Liquidity

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Government spending is a significant engine of deposit creation, accounting for 15% of GDP. However, money parked with the RBI is blocking deposit growth, with government cash balances with the RBI standing at ₹3.3 trillion.

Relief Options

The fastest relief would come from higher government spending, particularly on domestically sourced goods and services. Other options, such as encouraging overseas savings to flow back into India or increasing offshore borrowing by Indian corporates for domestic use, are less immediate.

Rethinking Fixed-Income Taxation

India's tax treatment of fixed income is less favourable than that of equity, with both interest income and long-term capital gains being taxed at marginal rates. Aligning these tax rates would reduce distortions, discourage tax-driven asset allocation, and encourage more balanced portfolios, ultimately supporting household participation in fixed income and strengthening deposit formation.