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 Indian banking system is facing a widening liquidity deficit, reaching levels last seen in 2016, that may prompt the central bank to provide another round of short-term cash infusion.

The Reserve Bank of India (RBI) pumped one trillion rupees ($12.01 billion) through a seven-day variable rate repo (VRR), marking the first such auction in six months, with one more anticipated on Friday, 10 traders and economists said.

"They should roll over the repo, or else there may be a selloff, at least in the shorter-end, (T-bills and up to three-year bonds), as most banks will face a shortfall," a treasury head at a state-run bank said.

Outflows toward advance tax payments and goods and service taxes have tightened liquidity and the situation is likely to remain unchanged through the month-end.

"The GST impact would be there for some time, so I think the RBI should roll over the repo, at least for a week, until the month-end spending comes in," said A Prasanna, head of research at ICICI Securities Primary Dealership.

Banking system liquidity deficit rose to 2.27 trillion rupees as of Dec. 20, registering its highest level since April 1, 2016.

Liquidity deficit is likely to increase in the near-term, and is expected to be comfortable only in the first quarter of 2024, Swati Arora, a senior economist with HDFC Bank, said.

Even after the VRR, overnight rates have stayed above the upper end of the RBI's policy corridor, highlighting the extent of cash squeeze.

Call rates could rise in the absence of a VRR rollover and create confusion on the RBI's liquidity stance, with almost the entire second half of December witnessing tight conditions, ICICI Securities Primary Dealership's Prasanna said.

RBI has largely pursued an aggressive liquidity withdrawal stance since August while ensuring that there is enough cash available for banks to meet their reserve requirement needs.

Banks have also turned to fundraising through certificates of deposit to address their cash needs.

($1 = 83.2675 Indian rupees)