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The deluge of money that has flowed into banks after the Narendra Modi government announced the withdrawal of high-value banknotes from circulation has complicated the task of the Reserve Bank of India (RBI). The liquidity shock has pushed down yields in the money market. The central bank has been sucking out the excess liquidity through reverse repo deals, but this has clearly not been enough to keep money market interest rates within the policy corridor. Banks have now been instructed to park all the incremental deposits they collected in the fortnight to 11 November with RBI.
The central bank says the new policy is a temporary response to the extraordinary episode of excess liquidity. What now needs to be watched is whether all the money that has flowed into banks as part of the currency exchange moves back into cash after a few months. In other words, will the excess liquidity automatically dry up? Meanwhile, India continues to face the strange combination of a cash shortage and excess bank liquidity.