Mumbai: Overnight rates should spring back to 6% come Monday from near zero after India’s central bank took steps to stamp out volatility this week. The measures also mean the rupee is unlikely to gain much for now.
Government bond yields are expected to rise above 8% when the Reserve Bank of India’s (RBI) ruling to increase reserve requirement kicks in this weekend and some of the surplus cash that has held yields near 7.7% for weeks drains out of the market.
On Tuesday, the central bank scrapped a Rs3,000 crore ($743 million) cap on funds it absorbs via its daily operations, meaning banks can now park more cash with it, and raised their reserve requirements by 50 basis points to 7%.
The cash reserve ratio (CRR) hike was unexpected but many thought the cap would go, as it was distorting bond yields and creating volatility in overnight interbank cash rates by setting a floor close to 0%.
Pre-emptive strike: RBI governor Yaga Venugopal Reddy ordered banks to curb lending and investment for the third time this year to soak up cash and keep a lid on inflation. Bloomberg photo (Prashanth Vishwanathan)
This was far below the 7.75% repo rate at which the central bank lends to the market and the 6% reverse repo at which it absorbs surplus funds from the banks.
“The removal of the cap on liquidity absorption will establish a floor under overnight rates at the reverse repo rate at 6%,” JP Morgan economist Rajeev Malik said in a report. “Given the current excess liquidity conditions, the change implies that the operational policy rate will effectively be the reverse repo rather than the repo rate.”
Bond yields have held near five-month lows for weeks due to the excess funds, but the 10-year yield has risen 15 basis points since Tuesday’s move to 7.9%.
Heads of treasury trading at Indian banks see it climbing to 8-8.1% in the coming weeks after Rs16,160 crore ($4 billion) is impounded as a result of the the reserve requirement increase on Saturday.
“The entire yield curve gets repriced due to this, and bond yields may rise further from current levels,” said Manoj Rane, country treasurer at BNP Paribas.
The 91-day treasury bill yield has jumped 2 percentage points in a week.
The five-year swap rate has gained nearly 30 basis points since RBI’s decision and the spread between the one- and five-year bonds has shrunk to 35 basis points from 66 two weeks ago.
Analysts say tighter cash and higher yields will lower the appetite for the market stabilization (MSS) bonds sold by the central bank to mop up rupee funds injected for heavy currency intervention.
“Sentiment has turned negative in the bond markets. The appetite for MSS issuances may dwindle and this will have an adverse effect on other segments of the yield curve as well,” ICICI Securities analyst A. Prasanna said.
By sucking out cash, the central bank has created more elbow room for intervention to stop the rupee from appreciating beyond 40.20 per US dollar—the nine-year high it hit last week.
RBI bought Rs92,920 crore ($23 billion) in first five months of the year to suppress the rupee, but the funds generated by selling rupees have largely contributed to the excess cash problem.
“The CRR hike has enhanced the RBI’s ability to intervene in the currency markets, as a higher CRR helps in absorbing a bigger portion of the fresh rupee liquidity,” ABN Amro economist Gaurav Kapur said. “It would continue to keep the rupee appreciation under check.”
Others say sucking out some cash is just a quick fix because the underlying capital inflow pushing the rupee up shows little sign of abating.
But it will calm the money market volatility and ensure overnight rates move in the official 6-7.75% rate corridor, putting monetary policy transmission broadly back on track.
“That degree of volatility is simply unacceptable and far in excess of what we believe is good for the system,” RBI governor Yaga Venugopal Reddy said after Tuesday’s policy review.