Is the Reserve Bank of India’s (RBI) seemingly contradictory signals – injecting funds into the banking system even as it pursues a policy of calibrated tightening – have left market participants guessing while short-term rates are rising. The RBI has injected Rs 2.5 lakh crore into the system even as it seeks to tighten monetary conditions following its 25-basis-point repo rate hike earlier this month.
SBI Research has argued that simultaneous liquidity injection and withdrawal send conflicting signals to the bond market. “With crude oil prices set to remain at elevated levels, domestic yields are unlikely to decline even as RBI may have given a contradictory signal on liquidity,” SBI Research said in a report. Such an approach, it said, was more appropriate for exchange rate management. The uncertainty comes at a time when banking system liquidity has fallen sharply, pushing up borrowing costs.
The one-month certificate of deposit (CD) rate has surged by more than 100 basis points to 6.76% in October, while the one-year rate has climbed 94 basis points, according to Bloomberg data. Market participants say the speed of the liquidity squeeze has caught them by surprise. “The pace at which liquidity has fallen to neutral is surprising. We consider Rs 50,000 crore as neutral. We were expecting this level to be reached by November or December,” said Alok Singh, treasury head at CSB Bank.
He said the rise in CD rates in just a month indicates that markets increasingly expect the RBI to maintain neutral liquidity conditions until March. While CD rates could soften after the completion of the Jio Platforms IPO, Singh believes they are unlikely to return to the levels seen a month or two ago. The higher rates will add to banks' funding costs and squeeze margins. Banks have already stepped up their dependence on market borrowings.
CD issuances rose to Rs 1.15 lakh crore in September, the highest in four months, according to RBI data. The liquidity squeeze has been particularly sharp in recent weeks. Banking system surplus fell to just Rs 31,254 crore on Thursday, its lowest level in three months, following Goods and Services Tax (GST)-related outflows. Average liquidity surplus declined to Rs 3.10 lakh crore in October from Rs 7.77 lakh crore in September.
This marks a dramatic reversal from September 6, when surplus liquidity had touched a record Rs 11.16 lakh crore, aided by strong inflows through foreign currency non-resident bank, or FCNR(B), deposits. 7; Input cost inflation eased, manufacturing strong However, the benefit of those inflows has not been evenly distributed across banks. “FCNR liquidity support has not been uniformly available across banks.
Therefore, CD rates have risen sharply. With credit growth remaining strong, banks may struggle to meet demand,” said the treasury head of a large private sector bank. The official believes the RBI is deliberately keeping liquidity tight to ensure that its rate hike is transmitted effectively across the financial system. As a result, banks should not expect any significant easing of liquidity conditions in the near term.
Several factors have contributed to the squeeze, including GST outflows, the increase in daily cash reserve ratio (CRR) maintenance requirements, foreign exchange intervention, higher currency in circulation and festive-season credit demand. “Overnight rates are rising amid tightening liquidity conditions. The pressure has become more pronounced following GST-related outflows, the increase in daily CRR maintenance, forex intervention, higher currency in circulation and stronger credit demand during the festive season,” said Mataprasad Pandey, vice-president at Choice Wealth.
Pandey expects liquidity to remain tight as the RBI may prefer elevated short-term rates to ensure faster transmission of its monetary policy stance. The pressure is already visible in the overnight money market. The weighted average call rate rose to 5.70% this week from an average of 5.56% in the previous week, according to Clearing Corporation of India Ltd (CCIL) data. With liquidity shrinking and overnight rates coming under pressure, the RBI began conducting fine-tuning operations through variable rate repo (VRR) auctions on Monday.
However, market participants believe these injections are aimed more at preventing excessive volatility than at easing monetary conditions. “Though VRRs are heavily oversubscribed during the day, the RBI’s decision not to follow a second one signals that it is unwilling to inject more liquidity than necessary to keep the market functioning,” said the private bank treasury official. The RBI is therefore expected to continue using VRR auctions selectively, providing just enough liquidity to prevent market disruptions without reversing the broader tightening trend.
Meanwhile, bond markets are pricing in the possibility of more aggressive rate hikes as elevated crude oil prices, inflationary pressures and currency volatility cloud the outlook. The RBI's decision on Wednesday to reject all bids at its Rs 23,000-crore Treasury bill auction across the 91-day, 182-day and 364-day tenors has reinforced concerns over rising borrowing costs. T-bill yields have already climbed 21 basis points over the past two weeks.
“T-bill yields have reset sharply in recent auctions as markets fear an aggressive rate hike at the next meeting. Expectations of a rate hike strengthened further amid elevated oil prices and concerns that the RBI may raise rates to stabilise the rupee, if needed,” said Abhishek Upadhyay, co-head of research at ICICI Securities Primary Dealership. Upadhyay expects core liquidity to decline to around Rs 3 lakh crore by March as the RBI progresses through its tightening cycle.
