BT Explainer: Why RBI is using VRRR to absorb surplus liquidity after record FCNR (B) inflows

The Reserve Bank of India (RBI) is stepping up its liquidity management operations as the banking system finds itself with a substantial cash surplus following unexpectedly large inflows through Foreign Currency Non-Resident (Bank), or FCNR (B), deposits.

The central bank is scheduled to conduct a ₹7 lakh crore variable rate reverse repo (VRRR) auction with a 30-day tenor on Monday, September 7, marking a significant move to absorb excess funds from the financial system.

The RBI has several instruments at its disposal to regulate and manage liquidity across the financial system.

The auction comes after the RBI's special FCNR (B) deposit scheme, announced in June, attracted around $127 billion—far above the market's initial expectations of $80-90 billion. The inflow was also significantly higher than the approximately $26 billion mobilised through a comparable window in 2013.

The large inflows have added to domestic liquidity, increasing the need for the RBI to prevent short-term interest rates from falling excessively and to keep monetary conditions aligned with its broader policy objectives.

What exactly is a VRRR auction?

The variable rate reverse repo, or VRRR, is one of the RBI's mechanisms for managing liquidity in the banking system.

Under a VRRR operation, banks temporarily park surplus funds with the central bank. Unlike a fixed-rate reverse repo operation, the interest rate in a VRRR auction is determined through competitive bidding.

The instrument is generally used for short-duration liquidity management, although the RBI can conduct operations with different tenors depending on prevailing conditions.

By absorbing excess cash, VRRR auctions reduce the amount of money immediately available to banks for lending and other market activities.

This becomes important when surplus liquidity pushes short-term money-market rates lower. If liquidity remains excessive for an extended period, it can weaken the transmission of monetary policy and potentially contribute to demand-side inflationary pressures.

Why has liquidity become a concern?

The latest liquidity surplus is closely linked to the unusually strong response to the RBI's FCNR (B) deposit scheme.

The foreign currency inflows have also contributed to a sharp increase in India's foreign exchange reserves. Reserves reached a record $740.8 billion in the week ended August 28, providing an additional buffer against external shocks and potential pressure on the rupee.

At the same time, government spending has continued to inject money into the banking system, adding to the liquidity surplus.

The challenge for the RBI is therefore not simply to ensure adequate liquidity but to prevent the system from becoming excessively liquid.

Growth remains strong, adding to the policy challenge

The liquidity issue comes against the backdrop of relatively robust economic activity.

India's real GDP expanded by 7.8% in the April-June quarter, outperforming expectations despite heightened geopolitical uncertainty.

At the same time, inflation remains an important consideration for policymakers. Consumer inflation was reported at 4.45% in April, compared with 4.38% in June, while market concerns remained over the possibility of higher price pressures later in the year amid geopolitical risks and weather-related uncertainties.

The RBI therefore faces the difficult task of maintaining sufficient liquidity to support economic activity without allowing excess funds to undermine its inflation-management objectives.

VRRR isn't the RBI's only option

The central bank has several instruments available if the liquidity surplus persists.

Economists have pointed to the possibility of additional VRRR auctions as one option. Other measures could include a temporary increase in the cash reserve ratio (CRR), which would require banks to hold a larger share of their deposits with the RBI.

The central bank could also use foreign-exchange-related tools, including sell-buy swaps, to manage liquidity.

Under a sell-buy swap, the RBI sells foreign currency to banks while agreeing to purchase it back at a predetermined date in the future.

According to Nomura Chief Economist for India and Asia ex-Japan Sonal Varma, the banking system is facing a situation of excess liquidity following the strong dollar mobilisation under the FCNR (B) scheme.

The surplus has contributed to the weighted average call rate—the rate at which banks lend to one another for very short periods—falling below the RBI's policy repo rate.

Some of the excess liquidity could naturally decline because of increased cash demand during the festive season, the maturity of forward positions and potential RBI intervention in the foreign exchange market.

However, if the surplus remains substantial, the central bank may need to deploy several liquidity-absorption measures simultaneously.

What to watch from the 30-day VRRR auction

The key question now is how strongly banks respond to the RBI's longer-tenor VRRR operation.

The size of the auction indicates the scale of the liquidity surplus confronting the central bank, but the amount actually absorbed will depend on banks' demand and bidding behaviour.

A strong response could signal that banks are willing to park a substantial portion of their surplus funds with the RBI. A weaker response, meanwhile, could indicate that lenders prefer to retain liquidity for lending and other market opportunities.

The September 7 auction will therefore provide an important indication of how effectively the RBI can absorb the surplus created by the record FCNR (B) inflows and whether additional liquidity-management measures may be required in the weeks ahead.