Monetary Policy and Fiscal Dynamics

The Reserve Bank of India's (RBI) significant open market operation (OMO) bond purchases and dividend transfers have supported the government's fiscal calculations by keeping yields low. This has been feasible due to moderate inflation, though it has implications for the external balance.

Money Creation Mechanisms

• Bank Loans: When banks extend commercial loans, they create money by crediting the borrower's account.
• Government Bonds: The RBI and banking system fund the government by purchasing bonds, injecting fresh money into the economy.
• Foreign Currency Inflows: Foreign currency converted into rupees creates new money.
• Bank Dividends: When banks pay dividends from their reserves, it results in money creation.

Money is retracted in the reverse scenarios, such as loan repayments or reduced government spending financed by banks.

RBI Dividends: Scale and Justification

Recent dividend transfers from the RBI to the government have been substantial. For FY25, ₹2.69 trillion was transferred, equating to 0.75% of GDP, following ₹2.11 trillion the previous year.

• Interest on Foreign Assets: Generates around ₹1 trillion in FY24, funded by non-interest-bearing liabilities.
• Government Bonds: Interest from government bonds held by the RBI, net of costs, was ₹0.9 trillion in FY24.
• Foreign Exchange Gains: Recognized ₹0.8 trillion in exchange gains in FY24, with net foreign currency purchases complicating the recognition of gains.

Current Monetary Landscape

As of January 2026, the money supply (M3) increased by 12% year-on-year, driven by a 14.1% growth in commercial credit. The RBI’s OMO purchases offset money drain from net FX outflows.

• OMO purchases in FY26 totaled ₹6.4 trillion by January 2026, easing monetary conditions.
• Pressure on the rupee persists due to low inflation and the impossible trinity theory.

Future Considerations and Structural Shifts

The RBI's ability to continue this magnitude of OMOs and dividends in less favorable environments is uncertain. Two key structural shifts are essential:

• Deepening Fixed-Income Markets: Encouraging household and non-bank participation to finance debt without creating new money.
• Reducing Revenue Deficits: Large central bank transfers mask underlying fiscal pressures; reducing revenue deficits is crucial for macroeconomic resilience.

Overall, the RBI's actions have significant impacts on money supply, interest rates, and external balance, necessitating careful policy considerations as inflation cycles change.