Why India's Liquidity Surplus Isn't Fueling Credit Growth—and What Investors Should Do

The Reserve Bank of India (RBI) has flooded the banking system with liquidity since late 2024, cutting rates and injecting over ₹9.5 trillion into the economy to counter a slowing growth trajectory. Yet, bank credit growth has stagnated below 10% in mid-2025—a stark disconnect highlighted by J.P. Morgan's recent analysis. This article explores why excess liquidity isn't translating into lending, the structural factors at play, and how investors can position portfolios to navigate these dynamics.

The Liquidity Paradox: Surplus Funds, Stagnant Credit

As of July 2025, India's banking system held a record ₹3.75 trillion in surplus liquidity—the highest since July . The RBI has deployed tools like 7-day variable rate reverse repo (VRRR) auctions to absorb excess funds, withdrawing ₹1 trillion in early July to prevent overnight rates from collapsing below the 5.25% floor of its policy corridor. Despite these efforts, credit growth has faltered. J.P. Morgan economists note that surplus liquidity primarily influences short-term borrowing costs (e.g., the Treasury Bills Rate of Exchange Settlement (TREPS)), not lending or deposit growth.

Why Liquidity Isn't Spurring Lending

1. Weak Credit Demand

Corporate and household borrowing remains subdued. Private investment, a key driver of credit growth, has been hamstrung by uncertainty over global demand, high inventory levels, and muted inflation. J.P. Morgan's analysis underscores that businesses are prioritizing balance sheet repair over expansion, while consumers remain cautious amid stagnant wage growth.

2. Asset Quality Concerns

Banks, still scarred by past non-performing asset (NPA) crises, are exercising caution. Regulatory capital requirements and risk aversion have led lenders to tighten lending standards, particularly for high-risk sectors like real estate and construction. This creates a supply-side bottleneck even as liquidity is ample.

3. Structural Shifts in Funding

The RBI's liquidity management has inadvertently reduced the incentive for banks to lend. With excess funds parked in risk-free reverse repo auctions yielding 5.25%, banks see little benefit in extending loans at higher but uncertain returns.

Implications for Investors

Sectors to Favor: Infrastructure and Bonds

• Infrastructure: Government capital expenditure (capex) surged to ₹1.6 trillion in April 2025, targeting projects like highways and railways. Companies exposed to this push—such as Larsen & Toubro (LT.NS) and National Highways Authority of India (NHAI)—could benefit from direct funding from the government, bypassing traditional bank credit.
• Fixed Income: The liquidity surplus has kept bond yields anchored. A shows yields hovering near 6.5%, offering stability for bond-heavy portfolios. Investors might consider ICICI Prudential G-Sec Fund (ICICIGSEC.NS) for yield-focused allocations.

Risks to Avoid

• High-Leverage Sectors: Real estate and construction firms dependent on bank credit (e.g., DLF (DLF.NS)) face risks as credit tightens.
• Weak-Balance-Sheet Banks: Regional lenders with poor asset quality (e.g., Yes Bank (YESBANK.NS)) may underperform if NPA concerns resurface.

Banking Sector Nuance

Not all banks are alike. HDFC Bank (HDB.NS) and Kotak Mahindra Bank (KTK.NS), which focus on retail lending and have strong capital ratios, are better positioned to weather the credit slowdown. Their shares could outperform peers if the RBI's liquidity management avoids excessive tightening.

Portfolio Strategy: Shift to Infrastructure and Diversify

Investors should:
1. Rotate toward infrastructure stocks linked to government capex.
2. Increase fixed-income exposure to capitalize on stable yields.
3. Underweight banks with high NPAs and overexposure to risky sectors.
4. Monitor the RBI's liquidity management: A will signal whether the central bank is succeeding in calibrating rates without stifling growth.

Conclusion

India's liquidity surplus isn't a panacea for stagnant credit growth. Structural factors like weak demand, regulatory constraints, and risk aversion among banks mean investors must look beyond traditional lending channels. By focusing on infrastructure, bonds, and select banks with robust fundamentals, portfolios can navigate this environment. As J.P. Morgan's analysis underscores, the RBI's challenge isn't just managing liquidity but reigniting credit demand—a task that may require fiscal stimulus or structural reforms, not just monetary tools.

Investors ignoring these dynamics risk being caught in a liquidity trap. The path forward lies in capitalizing on alternative growth vectors while hedging against prolonged credit stagnation.