According to data released on Wednesday, the liquidity gap in India's banking system reached a record high due to withdrawals for tax payments and reduced government spending. As a result, traders are expecting the central bank to inject additional funds to make up the difference.

If we look at the figures from the Reserve Bank of India (RBI), the deficit nearly tripled from the beginning of the month to Rs 3.34 trillion ($40.18 billion) as of Jan. 23. As per A Prasanna, head of research at ICICI Securities Primary Dealership, "the widening in deficit is a combination of rise in tax collections and a slowdown in government spending, which has been seen in the last few months."

Since overnight cash rates have continued to exceed the policy rate, Indian lenders have pushed the RBI to loosen liquidity constraints. The call rate was 6.85% on Wednesday, and the TREPS rate was 6.78%, both much higher than the 6.50 percent repo rate. The central bank hasn't injected longer-term money into the banking sector yet; instead, it has only held shorter-term repo auctions to inject cash.

"We believe that the RBI will maintain a liquidity deficit in the short run, but gradually reduce the size of the deficit as time goes on," said Parul Mittal Sinha, Standard Chartered Bank's head of financial markets in India.

"We believe that easing liquidity conditions towards neutral would be interpreted as a precursor to rate cuts," Sinha stated. RBI Governor Shaktikanta Das stated earlier this month that while inflation is still high, it would be premature to discuss a monetary policy change. As Rs 3 trillion in outstanding repos are set to maturity on Thursday, traders anticipate the announcement of another short-term repo auction shortly.

"In order to guarantee that liquidity needs are satisfied, RBI must continue implementing VRRs. Since government spending tends to increase before the fiscal year ends, we see potential for the overnight rates to rise towards repo by the end of March or the beginning of April, according to IDFC First Bank economist Gaura Sen Gupta.