RBI cash drain leaves short-term bonds more exposed to rising yields

India’s short-term government bonds are losing some of the support they received from record banking-system liquidity as the Reserve Bank of India (RBI) steps up efforts to pull excess cash out of the financial system.

The RBI held a 26-day variable rate reverse repo auction on 11 September, Friday morning seeking to absorb as much as ₹5 trillion from banks. The operation follows a succession of shorter auctions and signals that the central bank wants to keep a larger share of the surplus out of the market for longer.

Banking-system liquidity remained in surplus by about ₹10.5 trillion on Thursday, according to RBI data, after reaching a record in recent days. The glut stems largely from the RBI’s special dollar-rupee swap facility, which brought in far more foreign currency than markets had expected.

Banks mobilised $127.23 billion through Foreign Currency Non-Resident Bank, or FCNR(B), deposits by 31 August. Together with overseas foreign currency borrowings and external commercial borrowings, total inflows under the RBI facility reached $136.38 billion.

Banks then swapped much of that foreign currency with the RBI, receiving rupees in return and adding substantially to domestic liquidity. That cash had been particularly supportive for the short end of India’s government bond curve. Banks with surplus funds had more money to deploy in shorter maturity debt, while abundant liquidity kept overnight funding rates low.

The effect has also been visible in money markets. RBI data for 9 September showed the weighted average rate across the overnight market at 4.53%, well below the central bank’s 5.25% policy repo rate. The weighted average call money rate stood at 4.99%.

Bringing those rates closer to the policy rate has become a central part of the RBI’s liquidity operations. The bank has already been draining several trillion rupees at a time, although lenders have shown less appetite for committing cash for longer periods.

A 30-day VRRR auction on Monday attracted ₹2.59 trillion of bids against the ₹7 trillion the RBI had offered to absorb. The central bank accepted the full amount bid at 5.24%. Demand has been stronger for shorter operations. An overnight auction conducted Thursday attracted and absorbed ₹3.97 trillion against a notified ₹6 trillion, also at 5.24%.

The pattern suggests banks are willing to surrender large amounts of surplus cash while retaining flexibility over when they get it back. The RBI has also been using the foreign-exchange market to drain liquidity.

Traders said the central bank conducted dollar-rupee sell-buy swaps for a second consecutive day on Thursday, 10 September, with an estimated $600 million to $700 million transacted after about $1 billion the previous day.

Under a sell-buy swap, the RBI sells dollars in the spot market and receives rupees, removing those rupees from the banking system until the transaction is reversed. The swaps have another consequence. By pushing up forward dollar premiums, they can make it more expensive to hedge against rupee weakness and improve incentives for exporters to sell dollars forward.

The one-year annualized implied forward rate rose nearly 30 basis points over two days, according to traders, while the one-month premium climbed about 90 basis points. One basis point is one-hundredth of a percentage point.

For government bonds, the withdrawal of surplus cash matters most at shorter maturities. Those securities had been partly insulated from the global bond selloff because domestic banks were awash with cash. That cushion becomes thinner if the RBI succeeds in locking away a meaningful share of the surplus for weeks rather than days.

External pressure is meanwhile getting worse. Brent crude approached $110 a barrel in Asian trading on Friday as the Middle East conflict intensified. Higher oil prices pose a particular problem for India because of its heavy dependence on imported crude, raising risks to inflation and the country’s external balance.

US Treasury yields are adding to the strain. The 10-year yield rose to about 4.97% on Friday, close to 5%, as investors priced a higher probability of another Federal Reserve rate increase. The selloff has begun to show more clearly in India. The benchmark 10-year government bond yield moved above 7% on Friday for the first time in more than three months.

Indian debt had initially held up better than many overseas bond markets because of the extraordinary pool of domestic cash. The next test is whether the short end can continue to do so as the RBI removes more of that liquidity.