India's rupee liquidity has tightened due to income tax-related outflows, leading to increased funding costs and prompting banks to utilize the foreign exchange (FX) swap market to raise funds. The surplus rupee liquidity in the banking system fell below 700 billion rupees ($7.96 billion) on Wednesday, marking the lowest level in over four months, according to Reserve Bank of India (RBI) data. This decline is attributed to advance corporate and personal income tax payments, which had a Monday deadline.

As a result of the liquidity crunch, the weighted average tri-party repo (TREPS) rate rose to 5.52%, about 8 basis points higher than Wednesday. The overnight call rate also reached 5.65%, the highest in four weeks. Banks have turned to sell/buy dollar/rupee one-day swaps to raise rupee funds, which has pushed rates higher in the FX swap market. The Wednesday-Thursday swap rate climbed to 0.50 paisa, implying a rupee interest rate of over 6%, indicating banks' willingness to borrow at elevated costs via swaps.

According to a currency trader at a mid-sized private sector bank, FX swap rates have been trending higher, reflecting the ongoing and expected tightness in rupee liquidity. The trader noted that the pressure on liquidity is evident across markets, following a three-day variable rate repo (VRR) for 750 billion rupees conducted by the RBI on Tuesday, which saw a weak response. Banks are now paying rates above 5.51%, the level at which the RBI was offering to inject funds.

In response to the liquidity crunch, the RBI has announced a one-day VRR auction on Friday, with the aim of infusing 250 billion rupees. However, market participants view the auction size as relatively small. Liquidity conditions are expected to remain tight in the coming days due to upcoming Goods and Services Tax (GST) payments.

The current cash shortage is putting the Reserve Bank of India's toolkit to the test. While repo auctions offer a short-term fix, government tax demands are making funding conditions shakier than usual. If this crunch lingers, banks could have to pass higher borrowing costs along to businesses and households, possibly putting a damper on growth at a time when stability matters most.

In January 2025, India faced a severe liquidity crisis, with the deficit in the banking system reaching Rs 3.15 lakh crore on January 23. Factors contributing to this included GST payments, tax outflows, RBI's foreign exchange market intervention, and a fall in currency in circulation. The RBI has taken steps to improve liquidity, including variable rate repo auctions, dollar-rupee swaps and purchase auctions of government securities.