The net absorption of liquidity by the Reserve Bank of India (RBI) on Friday was about Rs35,000 crore, down 65% from the Rs1 trillion a month back and a far cry from the peak of Rs8 trillion in January. No wonder market chatter that liquidity is finally inching close to being neutral is growing louder.

The fact that RBI cancelled its plan to sell government bonds through open market operations (OMOs) last week added further mojo to this talk. Bond traders took this as a sign that the central bank is probably done with its OMO sales, rightly so since surplus cash is now reduced.

RBI’s absorption through its various daily reverse repo operations has dwindled but banks still hold close to Rs1 trillion worth of treasury bills, issued under the market stabilization scheme (MSS) to mop up the deluge of deposits in the aftermath of demonetization. These bills will mature in the fourth quarter of the fiscal year and will add to the liquidity. Considering that MSS under which these bills were issued has outlived its purpose, the possibility of RBI asking the government to issue a fresh batch to stem this inflow is low. Also, an exchequer already stretching its fiscal limits through bank recapitalization wouldn’t take kindly to added interest burden under MSS.

Dollar inflows into equity and bond markets continue to be strong. So far this month, Indian stocks have topped emerging markets by attracting close to $2.3 billion in inflows. Flows into bonds are even stronger. Bullish calls on equity and debt markets by foreign analysts suggest dollar inflows are unlikely to slow down and therefore potentially add to liquidity.

But there are potential drains on liquidity as currency in circulation continues to rise and credit growth is poised to pick up. The issuance calendar of the government bonds thins out during the fourth quarter given that the government frontloads its borrowing. For the March quarter this fiscal year, the issuance amounts to Rs66,000 crore, but this is something that the bond market can easily absorb.

Credit growth has recovered to 8.6% from a multi-decade low of 5% in the previous fiscal year. The narrowing of the credit-to-deposit wedge is a sign that banks won’t be left with a large chunk of money to park in the money markets.

Perhaps the money market saw this coming as rates on short-term paper have begun inching up this month as the adjoining chart shows. The bond market is anticipating a neutral level of liquidity before 2017 ends. The benchmark 10-year yield has already breached 7%. Given the thinning cushion of liquidity, rates across the curve have only one way to go—up.

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