A strong rally in India's short-end bonds, driven by foreign capital inflows, is at risk of fizzling out as the Reserve Bank of India (RBI) is expected to withdraw significant amounts of cash from the financial system. BofA Securities and Bandhan AMC Ltd. anticipate the RBI will increase short-term cash withdrawal operations in the coming months, projecting banking liquidity surplus to reach pandemic-era levels of approximately 8 trillion rupees ($85 billion). DBS Bank Ltd. also expects the central bank to utilize more potent tools, such as requiring banks to hold a larger proportion of deposits with the RBI, to manage the surplus.
The recent rally in short-end bonds has been primarily fueled by foreign investment after the government reduced taxes on debt for global investors on June 5. This led to a more than 30 basis point decline in yields on five-year notes, reaching 6.49%, outpacing longer-term yields and marking their largest monthly fall in over a year. However, analysts, including Ashhish Vaidya from DBS, believe there is limited room for further rally, especially considering the maturity of the RBI's short dollar forward book and the potential for a cash reserve ratio hike, which would reduce rupee liquidity.
Concerns about the bond rally's sustainability arise as the RBI, unlike other regional central banks, has maintained unchanged interest rates while employing other measures to support the rupee. Nevertheless, escalating inflation, with wholesale prices in May rising 9.68% year-on-year, and potential price pressures from a weak monsoon, may compel the RBI to raise rates later in the year. Deutsche Bank economists, for instance, foresee quarter-point hikes in both October and December. Rajeev Pawar, head of treasury at Ujjivan Small Finance Bank, expects five-year note yields to stabilize around 6.50% as the RBI uses reverse repurchase operations to absorb surplus cash.
The current liquidity surplus in the banking system, which dwindled to approximately 294 billion rupees by Wednesday from a high of 5.3 trillion rupees in April due to tax outflows, is projected to rebound towards the month-end due to state spending and the central bank's dividend transfer to the government. Measures introduced earlier in the month to attract foreign capital and bolster the rupee, including an incentive plan for overseas Indians on bank deposits and a program to boost foreign bond sales by state firms, could draw up to $80 billion. As banks exchange these dollars for rupees, it further contributes to the liquidity surplus, making it crucial for the RBI to reduce this excess liquidity to mitigate inflation risks.
