Mumbai: Government bond yields, along with the borrowing costs for banks and corporate entities, are dropping as the Reserve Bank of India’s (RBI) move to purchase dollars to prevent the local currency from strengthening has increased the supply of cash in the financial system.

Buying dollars from the spot market has infused liquidity into the system, which is helping bring down government bond yields by spurring demand for such bonds, bankers said. The yield on the benchmark 10-year bond fell to 8.63% on Friday, its lowest since January. It inched up to 8.67% on Monday.

Easier liquidity is also starting to reflect in the cost of funds for banks. The 12-month certificate of deposit rates have fallen to 9% currently, the lowest since November and down from its recent peak of 9.97% in April.

Borrowing costs for companies, as reflected in the 12-month commercial paper rates, have also eased to 9.42% now, from a recent peak of 10.23% in March and much lower than 11.75% in August last year.

Mohan Shenoi, treasurer at Kotak Mahindra Bank Ltd, said an improvement in the domestic economic sentiment and RBI’s intervention in the local foreign exchange (forex) market have boosted demand for bonds, but further easing in local bond yields will depend on whether RBI allows liquidity conditions to ease further.

“There is now hope that the new government will check the fiscal deficit and bring down inflation by addressing supply-side concerns. All this has led to dollar inflows which RBI has had to absorb, infusing rupees in the banking system," Shenoi said, pointing out that the overnight call money rate has eased closer to the 8% repo rate currently from 9% marginal standing facility (MSF) rate earlier.

MSF is the rate at which banks borrow emergency overnight funds, at a rate which is 1 percentage point higher than the repo rate.

Latest data from the central bank’s monthly bulletin shows that RBI bought dollars worth $7.78 billion in March to mop-up the excess dollar inflows and prevent the rupee from rising sharply. The data comes with a two-month lag.

The dollar buying by the central bank in March was the highest in three months and is not difficult to understand, because March received the highest inflows in fiscal 2013-14. During the month, foreign institutional investors (FIIs) pumped in $5.3 billion into the local debt and equity markets, according data from the Securities and Exchange Board of India (Sebi).

Ananth Narayan, co-head, wholesale banking, South Asia, Standard Chartered Plc, said that if the current rate of dollar buying from RBI continues, liquidity could improve further, triggering more demand for government bonds from banks.

RBI regulations mandate that banks invest at least 23% of their deposits into government bonds, even though at most times banks hold government bonds in excess of that.

“The fall in yield is also an indication of a stable currency. Foreign investors think India offering around 8.7% yield with better economic prospects and a stable currency is a better bet than countries like Indonesia which offer 7.5%," Narayan said.

Just like the 10-year government bond, the five-year bond yield has also eased to 8.62% currently, close to its January low of 8.51%.

Narayan of Standard Chartered said interest rates that had shot up following the rupee’s depreciation in July-August last year have now normalized. The rupee, which had tumbled to a lifetime low of 68.825 a dollar on 28 August, has recovered nearly 17.25% since then to 58.715 a dollar.

“The rupee is now relatively stable, so we can do with lower rates, but RBI has other concerns like high inflation which will prevent it from easing liquidity substantially," Narayan said.

In its bimonthly policy review in April, RBI had said it “will continue to monitor the liquidity conditions and actively manage liquidity to ensure adequate flow of credit to the productive sectors".

However, Indranil Sen Gupta, India economist at Bank of America Merrill Lynch, said it is unlikely that liquidity conditions will become surplus this fiscal.

“It is only after RBI has bought $44 billion that the question of sterilization will arise. Our balance of payments estimates place FY15 (fiscal year 2015) RBI forex intervention at a lower $ 33.9 billion (including maturity of forex swaps with oilcos, or oil companies). As a result, RBI will likely need to OMO $10 billion rather than sterilize forex intervention," Sen Gupta said in a note on Friday.

OMOs, or open market operations, allow RBI to infuse liquidity by purchasing government bonds from the market. In contrast, RBI can choose to “sterilize" excess domestic liquidity by selling some of its own stock of government securities through a market stabilization scheme.

Sen Gupta expects RBI to continue buying dollars to prevent the rupee from appreciation above 58 per dollar.