The Reserve Bank of India (RBI) sucked out liquidity of Rs 2.5 lakh-crore in November.

It did so using various tools — variable reverse repo, daily reverse repo, open market operations (OMO) sale of government bonds and cash management bills.

In a situation when the central bank is fighting inflation, excess liquidity can lead to pressures which the central bank does not want. Currency dealers say most of this liquidity was added due to the central bank's intervention in the foreign exchange market, where RBI was buying dollars through state-run banks.

“RBI wants to maintain tighter bias in the monetary policy. When there is ample liquidity, it creates pressure for interest rates to fall. This time, the credit demand is weak, too. In such a scenario, if there is so much liquidity in the system without genuine investment demand, that leads to inflationary pressures,” said Rupa Rege Nitsure, chief economist and general manager, Bank of Baroda.

In November the rupee had weakened by 1.1 per cent and currency dealers say most of this was due to state-run banks absorbing the dollar flows which were attracted by domestic markets.

“In the recent period, the rupee has been weakening and that is because the central bank continues to buy dollars to boost its reserves. Naturally, to absorb the rupee liquidity, RBI has been using various instruments,” said the head of treasury of a state-run bank.

Indian markets attracted flows from foreign institutional investors worth Rs 25,897 crore in November compared with Rs 18,345 crore the previous month.

“State-run banks were buying dollars on behalf of RBI. The buying was particularly more in the last week of November and as a result, the rupee breached the 62 mark on Friday,” said a currency trader of a leading treasury risk consulting firm.

Not all of the liquidity was added due to RBI’s dollar buying. “At the start of November, there was bond maturity which added to a liquidity injection worth Rs 46,000 crore. To suck this out, the cash management bills auction was held,” said Ashutosh Khajuria, president (treasury), Federal Bank.

RBI data show foreign exchange reserves fell by $672.4 million for the week ending November 21 to $314.88 billion. Currency dealers said the fall was probably due to revaluation of foreign exchange and not dollar sales by the central bank. RBI has been building reserves to prepare for the challenges when the US Federal Reserve begins raising interest rates in 2015.

It is broadly expected that there will be outflows from emerging markets, such as India, when this happens.