Banking system liquidity surplus has jumped to a record high of Rs 9.70 lakh crore as of 3 September, exceeding the Rs 9.20 lakh crore registered in September 2021.

The sharp spike in rupee liquidity has come due to the massive $127.23 billion banks raised through non-resident foreign-currency deposits. Most of this has been swapped with the central bank, resulting in this surplus liquidity.

The Reserve Bank of India (RBI) is facing a problem of plenty, complicating its job of managing liquidity and overnight rates.

"While some of the surplus...will be offset by higher cash in circulation during the upcoming festive season, maturity of forwards, and due to any potential RBI FX intervention, the RBI may have to employ a panoply of liquidity absorption tools to mop up this surplus," Nomura economists Sonal Varma and Aurodeep Nandi said in a note.

Traders are debating how the central bank may absorb these funds as allowing them to slosh around could fan already-rising inflation, news agency Reuters reported.

One way of tackling this liquidity deluge triggered by dollar deposits is for the RBI to conduct longer-term variable rate reverse repo (VRRR) auctions while giving banks the option to reverse them early.

The central bank routinely conducts overnight to seven-day VRRR auctions to suck out liquidity. Typically, these operations lock up liquidity for a few days.

"Repos conducted in the longer-term format saw reasonable success at the start of the calendar year, so it could offer a win-win solution for all parties," Reuters quoted a trader at a primary dealership as saying.

Another way for the central bank could be to use shorter tenor dollar-rupee sell-buy swaps. By selling dollars or taking delivery of a part of its forward positions, the central bank can drain rupee liquidity.

“Given the liquidity influx, the RBI may be comfortable in taking delivery of around $32 billion from its forward book, which is due to mature in one year,” Reuters quoted Madhavi Arora, an economist at Emkay Global, as saying.

The RBI and the government could also bring back the market stabilisation scheme. This was last used in 2017 after a decision to scrap high-value currency notes led to a surge in banking system liquidity.

The government under this scheme sells shorter-tenor Treasury bills, which could absorb surplus liquidity for up to one year.

The government is typically not in favour of this tool since it has to pay interest on these securities, Reuters quoted traders as saying.

Raising the cash reserve ratio (CRR), or the proportion of deposits that banks are required to hold as reserve, is the most commonly used tool to withdraw rupee liquidity. The CRR is currently at 3%.

Several market participants believe the central bank could temporarily raise banks' CRR requirement, particularly on deposits mobilised through the discounted window, the news agency reported.

Other traders say the central bank could opt for a broader CRR hike on all deposits.

According to estimates by market participants, a 50 basis point CRR hike could withdraw around Rs 1.4 lakh crore.

Another tool is for the RBI to sell government bonds that it is holding to investors. Such a move could withdraw liquidity but would also push up bond yields, Reuters reported.

"OMO sales could mitigate the risks associated with narrowing interest rate differentials," said Upasna Bhardwaj, chief economist at Kotak Mahindra Bank. "Based on our estimates of the RBI's holdings, most bond sales are likely to be concentrated in the three-year to 10-year segment."