RBI’s December Dilemma: When Growth Meets Liquidity
R Kannan
The air surrounding the December 2025 Monetary Policy
Committee (MPC) meeting of the Reserve Bank of India (RBI) is thick with
anticipation . On the surface, the Indian economy presents a picture of
enviable strength: Q2-FY26 GDP growth has dramatically outpaced forecasts,
proving the resilience and underlying momentum of domestic demand.
Simultaneously, the success of the Flexible Inflation Targeting (FIT) framework
is evident, with the Consumer Price Index (CPI) showing a steady downward
trajectory and hovering at its historical low. This combination of high
growth and low inflation has fuelled a widespread, almost consensus, demand
from industry for a substantial interest rate cut.
However, the duty of a central banker is to manage risks. For
the RBI, the apparent "Goldilocks" scenario is complicated by three
critical factors lurking beneath the surface: strained banking system
liquidity, persistent Rupee depreciation against the dollar, and the
narrowing interest rate differential with the US. These constraints
force the RBI to confront a fundamental policy choice: Could it pursue the
growth opportunity presented by low inflation, or could it prioritize the
financial stability threatened by capital flight and domestic funding
tightness? A singular rate cut, while politically popular, risks destabilizing
the progress made. The solution lies not in one lever, but in the sophisticated
and differentiated deployment of the entire policy toolkit.
The Alluring Case for Rate Accommodation
The primary argument for a repo rate reduction is
compellingly simple: the macroeconomic stability triangle—Growth, Inflation,
and Fiscal Prudence—appears well-balanced. With CPI comfortably below the 4%
target and trending lower, the RBI has successfully anchored inflation
expectations, providing the nominal policy space required for
accommodative action.
A rate cut would serve several vital functions:
- Lowering
the Cost of Capital: By reducing the policy rate, the RBI lowers the marginal cost of
funds for banks, encouraging them to pass on cheaper lending rates to
corporations and consumers. This is crucial for translating strong GDP
momentum into higher corporate investment, specifically in capacity
expansion, which has lagged in recent years.
- Boosting
Consumption and Housing: Lower EMIs would provide relief to existing borrowers
and stimulate demand for consumption durables and, critically, the
beleaguered real estate sector. This feeds back into a virtuous cycle of
demand-led growth.
- Sustaining
Previous Measures: It would logically complete the growth-boosting policy narrative
established in the previous MPC meeting, affirming the central bank’s
commitment to supporting the economy’s expansion phase.
To resist the temptation of a rate cut in this inflation
environment requires an iron will and a clear understanding of the financial
plumbing, which is currently emitting distress signals.
The Critical Constraints: Stability Over Signals
The ultimate goal of the RBI is not merely growth, but sustained,
stable growth. The current environment possesses three deep-seated
fragilities that a rate cut would immediately and severely aggravate,
demonstrating a failure of pragmatic central bank practice:
1. The Banking Liquidity Crisis: A Bottleneck to Credit
Transmission
The most pressing domestic concern is the status of the
banking system. The data is clear: liquidity in the banking system is at a
low level. While bank credit growth remains healthy at approximately 10%,
bank deposit growth is also hovering at this mark. This near-equal growth
indicates a fundamental tightness in the system—banks are lending almost as
fast as they are garnering deposits, leaving little surplus for further
expansion.
A rate cut now would be ineffective and potentially
counterproductive.
- Ineffective
Transmission:
Banks facing liquidity shortages will not pass on the full policy rate
cut. They may keep their lending rates elevated to preserve margins and
attract scarce deposits, leading to a disconnect between the policy signal
and its real-world impact.
- Disincentivizing
Deposits: A cut
would further lower deposit rates. In a high-growth environment,
households and corporations are already seeking higher returns elsewhere
(equities, bonds). Reducing deposit returns would widen this gap, slowing
the pace of deposit mobilization and starving banks of the necessary
funding base to support the current 10% credit growth. This risks an
internal, self-inflicted credit crunch.
2. The Rupee and the Narrowing Differential
Externally, the situation demands extreme caution. The Rupee
has depreciated against the dollar by close to 5%—a significant movement that
pressures corporate import costs and raises inflation risk. This depreciation
is exacerbated by the narrowing interest rate differential between the US and
India.
- Capital
Outflow Risk:
As the differential shrinks, the risk-adjusted return for Foreign
Institutional Investors (FIIs) holding Indian debt diminishes. This
incentivises capital flight—the repatriation of funds to
higher-yielding US assets or other emerging markets.
- Best
Practice Counter-Cyclical Policy: A core central bank best practice in managing capital
account volatility is to maintain an adequate interest rate premium,
particularly when external factors (like persistent punitive import
tariffs by the USA) are already creating trade imbalances. A rate cut
would be a direct signal to FIIs that the premium is evaporating,
accelerating capital outflows and compounding the pressure on the Rupee.
The RBI can use its interest rate as a tool to maintain currency
stability, which is vital for long-term growth and confidence.
The Policy Prescription: Differentiated Tool Deployment
The RBI cannot afford a 'one-size-fits-all' policy. To secure
growth, liquidity, and currency stability simultaneously, the MPC can employ a
strategy of differentiated tool deployment, separating the policy rate
from liquidity management:
I. Interest Rate Decision: A Strategic PAUSE
The MPC can hold the Repo Rate unchanged at its
current level.
This move is not hawkish; it is strategically stabilizing.
It sends a clear, unambiguous signal to global investors that the RBI is
prioritizing currency stability and prudent financial risk management
over a short-term political dividend. This pause acts as a necessary anchor for
the Rupee, helps to re-widen the interest rate differential, and buys the
economy time until the global interest rate environment, particularly the US
Fed's stance, becomes clearer. The MPC can communicate this pause as a "stability
measure" that enables future growth, not as a tightening of the
monetary cycle.
II. Liquidity Management: Aggressive Easing
Since the problem is liquidity, the solution can be
liquidity. To address the tightness and support the domestic credit
transmission without cutting the repo rate, the RBI can aggressively and
transparently use its non-rate tools:
- Operation
Buy: Durable Liquidity Injection (OMO): The RBI could announce a calendar for
significant Open Market Operations (OMOs) to purchase Government
Securities (G-Secs). This action directly injects durable, high-powered
money into the banking system, immediately alleviating the low
liquidity status. This is the most effective way to give banks the
reserves they need to sustain credit growth without placing downward
pressure on the policy rate or deposit rates.
- Long-Term
Repo Operations (LTROs): To encourage term lending and confidence, the RBI could
announce targeted LTROs at a rate linked to the policy rate. This
would provide banks with stable, long-term funds to confidently underwrite
long-duration projects, such as infrastructure and industrial CAPEX, which
are essential for sustained growth.
- Refining
the Cash Reserve Ratio (CRR): While a blunt instrument, the RBI could consider a
marginal, symbolic reduction in the CRR. This action directly frees
up locked reserves, offering immediate, system-wide liquidity relief and
reinforcing the message that the central bank's stance on domestic
funding remains highly accommodative, even if the policy rate is on
pause.
The Long-Term Imperative: Financial Stability as the Growth
Bedrock
The December 2025 MPC meeting is a test for RBI. The greatest risk to India’s high-growth narrative
is not a minor deviation from the inflation target, but a full-blown financial
stability event triggered by capital flight or a domestic credit seizure.
By holding the repo rate, the RBI protects the external
account and manages capital flows. By simultaneously easing liquidity through
OMOs and other term tools, it supports the domestic credit cycle and validates
the strong GDP growth. This differentiated approach, which is the hallmark of
modern, sophisticated central bank practice in open economies, ensures that the
strong growth of Q2-FY26 is not a fleeting peak, but a stable, well-funded
platform for India’s ascent into the next fiscal year. The correct policy
is one that prioritizes stability today for sustained growth tomorrow.
9
