Domestic prices have been gradually inching upward. The April data for retail inflation - reflecting the March numbers - stood at 3.48%. It has been raising its ugly head since then. While it was 4.45% in July, analysts projected it to rise further in August, the details of which will be announced next week. 

The hydra-headed problem is undoubtedly being driven by global energy and commodity prices along with the falling value of the domestic currency.

FCNR(B) Swap Window

The problem, however, has acquired another dimension, thanks to the special Foreign Currency Non-Resident (Bank) or FCNR(B) swap window opened by the RBI to mop up non-resident Indian (NRI) deposits. This has led to an excess of dollar-induced liquidity for India’s commercial banks. 

To prevent the surplus money from fuelling inflation, the RBI went into an overdrive to suck excess liquidity from the system through aggressive variable-rate reverse repo (VRRR) auctions - almost on a daily basis since August.

This has been one of the most aggressive and unprecedented drives by the RBI.  The worried central bank has on several occasions conducted two VRRR auctions in a day.

Draining excess cash is also important for anchoring the call money rate near the repo rate and ensuring the transmission and efficacy of the monetary policy actions.

India’s Inflationary Pressure

As regards inflation, the central bank is mandated by the government to maintain the Consumer Price Index (CPI), or retail inflation, at 4% with a margin of 2% on either side. According to RBI Deputy Governor Poonam Gupta, it is projected to peak at 5.9% in the October-December quarter of the current financial year.

 “…given that the headline inflation is projected to peak to a level as high as 5.9% in Q3 2026-27, a case for a (rate) hike may emerge during the course of the year”, she had opined during the bi-monthly Monetary Policy Committee (MPC) meeting last month.

RBI Governor Sanjay Malhotra too said that “re-escalation of the (West Asia) conflict since the first week of July has amplified volatility in energy prices and renewed uncertainty about supply chains.” Going forward, he added, “El Niño’s impact on temporal and spatial rainfall distribution continues to remain a major risk.”

In this backdrop, the RBI’s actions to contain the impact of a liquidity deluge on the economy become even more important.

Special FCNR(B) Window And Liquidity

The problem of excess liquidity was triggered by the RBI’s decision to open a special dollar-rupee swap window in June 2026 to garner NRI funds, with a view to checking the sliding value of the rupee against the US dollar. 

The response from NRIs to the special FCNR(B) scheme was overwhelming, prompting the Reserve Bank to shut the special window a month ahead of the scheduled date.

An analyst, without wishing to be named, said the move was aimed at containing the slide of the rupee. 

“Even as foreign exchange reserves remained above the US$ 680 billion, enough to cover 11 months of export bill, the RBI decided to launch this scheme. It was clearly intended to support the Indian rupee,” the analyst said, adding the Reserve Bank’s decision had burdened the economy with more problems.

The fallout of this costly endeavour of the Reserve Bank will be on inflation, servicing of expensive deposits and reduced surplus transfer to the central government, the analyst pointed out.

As the FCNR(B) scheme was considerably sweetened by the RBI, the commercial banks managed to mobilise about US$ 127 billion to US$ 137 billion and swapped it with the central bank. These swaps injected Indian rupee into the banking system, pushing the surplus from about ₹1 .6 lakh crore at the beginning of the year to ₹10-11 lakh crore by early September. 

“This deluge of NRI funds forced the RBI to abruptly cut short the swap window,” the analyst said. 

A calibrated increase in liquidity is welcome because it can be absorbed by the system and put to effective use. However, the deluge of funds during a short period of time created a problem for the money market, banking system, and the broader economy. Because of the excess liquidity, the overnight interbank call money rate drifted below the repo rate of 5.25% and the standing deposit facility (SDF) rate of 5%.

Call Money Rate, Repo Rate And SDF 

Overnight interbank call money rate is an important barometer of liquidity in the system. 

Call money rate refers to the interest rate at which banks and financial institutions lend and borrow money from one another for a short period of time, usually overnight. Borrowing banks use the money to meet a temporary shortage of funds, manage day-to-day liquidity, and maintain statutory cash reserves.

While a high call money rate is an indication of a liquidity shortage, low rates are suggestive of excess or easy liquidity conditions in the system. Ideally, the call money rate should be around the repo rate at which commercial banks can borrow money from the RBI for a short period against a collateral of government securities.

On the other hand, under SDF (Standing Deposit Facility), banks can park surplus funds with RBI overnight and earn interest.

On account of the upsurge in dollar-driven funds, the call money rate slipped below the repo rate and the SDF rate, indicating the presence of excess liquidity in the market.

According to the Clearing Corporation of India Limited (CCIL), the weighted average call rate (WACR) fell to around 4.93–5.02% in early September - below the 5.25% repo rate and, at times, the 5% SDF floor.

The Reserve Bank has been trying to correct this distortion in the money market by coming out with a series of VRRR auctions to absorb excess liquidity in the system.

Variable-Rate Reverse Repo (VRRR) Auctions

In the reverse repo operations, the Reserve Bank borrows money from the banks for short periods and pays interest.

The process starts with an RBI notification which specifies the tenor -- which may be overnight, 3-day, 7-day, 15-day, 30-day -- and the amount to be raised. The banks are required to submit their bids indicating the amount and the interest rate at which they are willing to park their surplus funds with the RBI. Once the bids are received, the RBI accepts those which are within the cut-off interest rate range.

By this exercise, the Reserve Bank effectively sets the market-determined interest rates for short-term borrowings. The VRRR auctions also allow commercial banks to earn interest on idle cash and enhance treasury income.

The VRRR is one of the tools by which RBI absorbs excess liquidity from the system. It could also be done by using blunt instruments like Cash Reserve Ratio (CRR) or Statutory Liquidity Ratio (SLR). However, as these are not market-determined, they ought to be avoided to the extent possible.

In a bid to neutralise the impact of the dollar-driven liquidity deluge, the RBI has been running VRRR auctions almost on a daily basis, with tenors ranging from overnight to 30 days and notified amounts sometimes exceeding ₹10 lakh crore in a single day.

According to Madhavankutty G., group chief economist at Canara Bank, “Liquidity is surplus at present, but it will moderate due to advance tax flows, IPOs and other factors. Credit growth running at 17-18% also means banks need liquidity, which is why the recent VRRR auctions did not see much demand from banks." 

Reserve Bank’s Twin Objectives

The main objective of the Reserve Bank’s aggressive VRRR auctions is to maintain the sanctity of the policy corridor by absorbing excess liquidity in the system and lifting the call money rate to the level of the repo rate of 5.25%. Secondly, to ensure that excess funds do not fuel inflationary expectations and breach the Reserve Bank’s upper band of 6% at a time when the West Asian crisis is refusing to abate, and the impact of El Niño is yet to fully unfold.

Pitching for more concrete action by the central bank, Madhavi Arora, lead economist at Emkay Global, said: “Limited success of the VRRRs implies that the overnight rates could stay lower than the policy rates unless some other durable tools of sterilisation are taken by the RBI.”