India rates: Excess liquidity attracts the RBI’s hand

Paving ground to increase reverse repo rate by end-year
Radhika Rao09 Sep 2021
    Photo credit: Unsplash Photo

    In an indication that the current surplus liquidity is beyond comfort levels, the RBI conducted an additional 7-day variable rate reverse repo operation (VRRR) worth INR 500bn earlier this week, ahead of a scheduled 14-day INR 3.5trn due today. Banking system liquidity surplus is at multi-year highs >INR10trn, spurred by pandemic-driven support measures including bond purchases under the G-sap program, roll-off of RBI’s FX forward book and high government cash balances. The size of the VRRR auctions which started the year at INR2trn, will increase in a staggered manner to INR4trn by Sept 24, as announced in the August rate review.

    The impact has been largely muted by far with cost of short-term borrowings little moved. For instance the weighted call money rate (15day average) is below the reverse repo rate, overshadowed by the liquidity surfeit. Whilst the RBI was keen for the markets to not interpret liquidity absorption as a departure from its accommodative policy stance, the strong surplus is likely spurring concern over a potential distortion in risk pricing. This additional liquidity absorption briefly pushed 10Y INR govvie yield (generic) higher before settling back down between 6.10-6.20%.

    We expect further liquidity absorption steps via longer-tenor and larger size auctions in Oct-Nov to set the stage for normalising policy via an increase in the reverse repo rate by end year. For a material impact on the cost of borrowings, incremental cash infusion will also have to moderate, by way of lower quantum of bond purchases (vs INR2.2trn in 1Q-2QFY22), drawdown of the government cash balances and higher currency in circulation as the festive period approaches. 

    On the data front, August CPI inflation, due Monday, is expected to rise 5.7% yoy and drift lower over the remaining months of 2021 on base effects and ebbing food prices. Monsoon shortfall, fuel price rigidity, service sector reopening gains and pass through of higher input price pressures are, however, likely to act as counterbalancing forces, preventing a sharper deceleration in the sequential pace and keep inflation above target. The central bank’s revised forecasts already accommodate upside risks to inflation, with the outcome unlikely to influence policy in either direction.   


    Radhika Rao

    Economist – India, Indonesia, Thailand & Eurozone
    [email protected]


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