India's banking system liquidity deficit widened on Tuesday to the highest in nearly five years on monthly goods and services tax payments, but economists are hopeful the gap will narrow next week.

       The liquidity deficit - the amount of funds banks need to borrow from the interbank market or from the central bank - stood at 1.74 trillion rupees ($20.90 billion) on Tuesday, according to data from Reserve Bank of India (RBI).

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       The deficit was the highest since Dec. 26, 2018, when it had hit 1.86 trillion rupees, according to economists.

       "We have seen GST outflows of around 1.4 trillion rupees since Monday," a banker at a state-run lender said.

       "Outflows of around 120 billion rupees-130 billion rupees are expected, so the deficit will widen further." The RBI has tightened monetary policy to curb inflation and said in October it plans to sell bonds through auctions to manage banking liquidity.

       Tax payments lead to an outflow of funds outside the banking system.

       In a sign of the liquidity crunch, overnight money market rates have been trading above the RBI's Marginal Standing Facility rate of 6.75%.

       A seasonal pick up in 'currency leakage', the balance of payments turning mildly negative and a slowdown in foreign inflows are putting pressure on liquidity, Gaura Sengupta, India economist at IDFC First Bank, said.

       Tight liquidity in the coming months will mean that there may not be space for the RBI to sell bonds until December, Sengupta said.

       A "break" in government spending amid elections in states is hurting liquidity, Anitha Rangan, an economist at Equirus Group, said.

       "This could be a blip and spending is expected to pick up in Jan-Mar before we head into the general election," Rangan added.

       Banking liquidity should get a boost next week with a pick up in government spending and bond redemptions but it will not shift to a surplus, Soumyajit Niyogi, director of the core analytical group at India Ratings & Research, said.

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