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The liquidity glut and the crash in short-term rates has meant that analysts are expecting some wordplay by the central bank and perhaps even measures to address this.
The liquidity glut and the crash in short-term rates has meant that analysts are expecting some wordplay by the central bank and perhaps even measures to address this.

India’s bond market is bracing for liquidity vigilance from regulator

  • The  spread  between one-year and 10-year bonds has widened by 20 basis points over the past month
  • Gap between 5-year bond and the 10-year benchmark paper has grown to 80bps from 70bps a month ago

The Reserve Bank of India’s rate-setting committee would make public its vote on interest rates and policy stance on Friday. Analysts expect some wordplay from RBI on liquidity, given the crash in short-term rates recently.

But markets seldom sit around for the actual outcome. Bond investors seem to have already figured out the beginning of the end of this liquidity story.

Also read: India’s quest to fix its payments puzzle

The benchmark 10-year government bond yield has inched up 5 basis points (bps) in the past week. One basis point is one-hundredth of a percentage point. Notwithstanding the crash in short-term rates, the sovereign yield curve has been steeper than expected.

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The spread between one-year and 10-year bonds has widened by 20bps over the past month. The distance between 5-year bond and the 10-year benchmark paper too has widened to about 80bps from 70bps a month ago.

This suggests that markets are expecting the monetary policy to throttle back from its accommodative stance. In fact, yields are pricing in the implications of this in the medium term.

“On Friday, if we see some statement around liquidity, yields would move up some more," said a bond trader, requesting anonymity.

The fall in short-term interest rates has triggered a debate over whether it is time for RBI to tone down its liquidity accommodation. As argued by this column on Monday, the surfeit of liquidity has complicated pricing of risk for lenders.

Analysts have prescribed several measures that could sterilize the impact of liquidity.

One solution for RBI is to issue market stabilization scheme (MSS) bonds. These 1-3 year bonds can be used to offset the addition to liquidity through dollar purchases.

MSS bonds have been used by the central bank in the past extensively for this purpose. “The MSS would reduce the liquidity surplus and create room for RBI to conduct OMO (open market operations) purchases," wrote Anubhuti Sahay, head of South Asia economic research (India) at Standard Chartered Bank in a note.

Yet another solution has been to normalize the cash reserve ratio (CRR) requirement for banks.

“Some possible tactical measures that RBI can take is to pre-pone the normalization of CRR in a calibrated manner," said Soumyajit Niyogi, associate director at India Ratings.

On 27 March, RBI had lowered the CRR by 100bps to 3%, but restricted this leeway up to March 2021. Reinstating the CRR to 4% early on would immediately impound liquidity with little damage.

It remains to be seen whether the central bank will announce measures to offset the surplus liquidity. But the bond market is bracing itself for at least a statement towards the same.

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