At first glance, India’s short-term interest rates should be falling rapidly. They aren’t.
The Reserve Bank of India has cut the repo rate to 5.25%, committed to maintaining ample liquidity, and has already conducted open market purchases of ₹4 trillion since August 2025 (excluding secondary market interventions).
In such an environment, short-term borrowing costs should logically be lower - if anything, it is long-term yields that may remain sticky due to “end-of-cycle” concerns. Instead, one-year certificate of deposit (CD) rates for leading banks are hovering around 6.90% (a recent high of even 7.15%), up nearly 35-40 basis points over the past three months. This is a clear signal that something is not working as intended. The root cause seems that banks are still scrambling for deposits.
Credit Is Growing Faster Than Deposits
Currently, credit growth continues to outpace deposit growth, tightening funding conditions despite RBI liquidity support. In theory, RBI’s bond purchases inject cash into the banking system. As banks lend this money, deposits should be created. But this mechanism breaks down if borrowing is used for imports, overseas travel, or international payments. In those cases, deposits simply exit the domestic system.
India remains a current account deficit economy. The deficit stood at USD 23 billion in FY25 and USD 15 billion in the first half of FY26. Ideally, foreign capital inflows - FDI or portfolio investments - would offset this leakage. But inflows have not been sufficient. The delay in India’s inclusion in the Bloomberg Global Aggregate Bond Index has further reduced a potential source of foreign capital, bringing in overseas savings.
More Digital Payments, Yet More Cash
Adding to the strain is a paradoxical trend. Even as digital payments surge, currency in circulation has risen sharply - now at ₹40 trillion, higher by more than 10% year-on-year.
The reasons are not fully clear and remain partly anecdotal. Stronger rural economic activity, which is still cash-intensive, and higher real estate transactions are often cited. Regardless of the cause, rising cash usage drains liquidity from banks because physical cash circulates at a slower pace.
Liquidity Parked, Not Circulated
Government spending is one of the largest engines of deposit creation, accounting for roughly 15% of GDP. When the government spends domestically (as opposed to imports for say defense), deposits are created. However, money parked with the RBI does blocks deposit growth - currently, government cash balances with the RBI are elevated, at around ₹3.3 trillion.
So, What Could Ease the Pressure?
The fastest relief would come from higher government spending, particularly on domestically sourced goods and services.
Other options exist but are less immediate. Encouraging overseas savings to flow back into India - similar to the FCNR(B) scheme introduced under former RBI Governor or Increased offshore borrowing by Indian corporates for domestic use are possible avenues.
A weaker rupee could also slow outbound spending and imports, forcing savings to stay onshore. But this is a blunt and painful adjustment. It would raise the cost of essentials such as crude oil, food, and electronics, hurting consumers—especially lower-income households. This is not a solution one should wish for lightly.
Rethinking Fixed-Income Taxation
Perhaps the Government missed a beat in the Budget on a potential durable solution. India’s tax treatment of fixed income is less favourable than that of equity – as both interest income and long term capital gains being at marginal tax rates. Aligning these tax rates would reduce distortions, discourage tax-driven asset allocation, and encourage more balanced portfolios.
That, in turn, would support household participation in fixed income, strengthen deposit formation, and improve the resilience of India’s financial system - benefiting both investors and the broader economy.
(Vivek Ramakrishnan, Vice President – Investments, Fixed Income and Kunal Khudania, Fund Manager at DSP Mutual Fund.)