Then he dropped the bomb – OMO sales. That means the central bank will sell government bonds from its vaults and drain the excess cash floating in the system.
All the gains that government bonds had logged over the past few weeks in anticipation of JPMorgan Index inclusion, evaporated. Bond yields spiked 12 basis points to the highest this fiscal year – at 7.34%.
Bond yields and prices move in opposite directions. A basis point is 0.01 percentage point.
For a market that was factoring in bond purchases by the central bank in the second half of the fiscal year, the contrary event was a shock.
To be sure, the RBI, since the beginning of the tightening cycle in May 2022, has been talking about focusing on the withdrawal of accommodation. Nearly 17 months later, the situation is hardly what the RBI wanted: By September-end, core liquidity was ₹2.8 lakh crore and that is set to rise to ₹3.3 lakh crore with the total withdrawal of the Incremental Cash Reserve Ratio.
“If you see, the liquidity is surplus,” said Governor Das. “We have announced withdrawal of ₹2,000 notes. The ₹2,000 notes that we have got back so far are about ₹3.43 lakh crore and only about ₹12,000 crore or so are left. Of this, 87% has come as bank deposits.”For a central bank that is tightening monetary conditions to fight inflation, that is hardly a good position to be in. In a way, the ground realities were out of sync with the intentions of the stated monetary policy goals.
So much so that the overnight call rates in August were below the repo rate of 6.5%, reflecting that the market is doing something the RBI did not want.
“Focus remains on keeping liquidity conditions tight as transmission of past rate hikes remains incomplete,” said Gaura Sen Gupta, economist at IDFC First Bank.
While much of the focus is on interest rates when it comes to monetary policy, liquidity plays a bigger role in realising the objectives of the central bank.
Unlike developed economies’ central banks, the RBI is active in the currency markets, watches the bond market yields and builds foreign exchange buffers.
Furthermore, the withdrawal of ₹2,000 banknotes complicated the liquidity management.
When developed markets are witnessing record tightening, with the US ten-year bonds at 4.7%, it may not be reasonable to expect the RBI to leave Indian markets in a surplus that militates against the stated stance of withdrawal of accommodation.
Overseas fund flows into India have been strong and the inclusion of India in the JPMorgan Emerging Markets Bond Index is likely to pull in another $20 billion. When that flows in, the RBI may have to buy US dollars as part of its currency management. That means additional liquidity into the system.
The RBI has to conduct an independent monetary policy, smoothen volatility in exchange rates and ensure capital flows freely. It’s an impossible trinity to manage.
The bond purchase plan may have jolted the market, but that probably saved it from a bigger shock later in the year – and without prior notice.