India's central bank will likely shift to withdrawing liquidity from the banking system and opt for a variable rate reverse repo auction on Friday to balance a recent surplus, six traders said on Thursday.

"The Reserve Bank of India will not leave a large surplus in the system and they should conduct reverse repo auctions and move the money out," said Vijay Sharma, senior executive vice president at PNB Gilts.

The variable rate reverse repo, or VRRR, is a tool the cenbank uses to take out surplus liquidity in the system by withdrawing cash. The Reserve Bank of India's announcement for a 14-day repo or reverse repo auction is due later today.

Opting for a VRRR would be ideal, provided the central bank keeps the quantum at 500 billion rupees, "or else it will have a negative impact on rates," the head of treasury at a state-run bank, who did not want to be named because they are not authorised to speak to media.


The RBI surprised market participants on May 18, when it announced a 14-day repo auction worth 500 billion rupees ($6.06 billion) to infuse funds into the system.

However, banking system liquidity surplus has swelled since then, thanks to redemption of debt securities, increased government spending and the central bank's move to withdraw the highest denomination 2,000 rupees notes.

Over 1 trillion rupees of inflows were accrued in mid-May from maturing bonds, while traders estimate that around 300 billion rupees to 500 billion rupees has come back into the banking system from currency withdrawal. Currency in circulation dropped by 365 billion rupees in the week ended May 26, latest data shows.

The latest surplus figure stands at 1.76 trillion rupees, nearly double of what it was in the previous fortnight.

However, some market participants say the improved liquidity surplus will not last for long.

"Only a small percentage of cash economy will be converted into banking economy from the 2,000 rupee note withdrawal," said Rajeev Mohan, president treasury & global markets at Kotak Mahindra Bank.

"This amount will be distributed in three to four months, and hence the impact would be muted. The RBI should continue with VRR for June, as need for funds may be higher." ($1 = 82.4050 Indian rupees)

(Reporting by Dharamraj Dhutia)