RBI is on active liquidity management mode

Gaura Sengupta - IDFC first bank

The focus of the monetary policy continues to be on using liquidity conditions to keep overnight rates closer to the marginal standing facility (MSF) rate of 6.75 percent, rather than the repo rate of 6.50 percent.

This was first achieved by the incremental cash reserve ratio (I-CRR), which temporarily removed Rs 1.1 lakh crore of liquidity in August. The subsequent phased removal of I-CRR spread over September and the first week of October ensured that liquidity conditions remained tight.

Indeed, since the advance tax payment due date (September 15), the liquidity deficit in the second half of September has averaged Rs 1 lakh crore a day, resulting in overnight rates rising to the MSF rate, which is 25 basis points (bps) higher than the repo rate.

In the October policy, the Reserve Bank of India indicated that it was considering sales via open market operations (OMO) as a liquidity-absorbing tool. Though the RBI didn’t specify an amount, the quantum will depend on prevailing liquidity conditions.

During the post-policy press conference, the RBI said OMO is a liquidity management tool, but the markets have taken it as a yield signal, resulting in government security yields rising. This is because the explicit reference to conducting OMOs comes when liquidity conditions have already tightened significantly.

BoP mildly negative

Moreover, in the second half of the financial year, liquidity will tend to naturally tighten with the rise in currency leakage during the festive season.

External conditions have changed, with the balance of payments turning mildly negative (capital outflow) in Q2 of FY24 after a substantial surplus of $24.4 billion in Q1 (capital inflow). The change in external conditions is due to the widening trade deficit and a slowdown in foreign portfolio investment inflows.

The combination of dollar strength and elevated crude oil prices indicate that the balance of payments could remain negative in Q3 also, resulting in further tightening of liquidity conditions.

The RBI’s intent to keep liquidity conditions tight is reflected in its past actions, not limited to the implementation of I-CRR. The central bank conducted a small quantum of OMOs (unannounced) in September of Rs 7,400 crore (net). Interestingly, the majority of OMO sales was in the second half of September, when liquidity conditions had tightened significantly.

Hence, the RBI is likely to persist with OMO sales in the coming months, even as liquidity conditions have tightened. The explicit reference to OMO auctions indicates that the quantum could be larger than what was conducted in September (unannounced).

Looking at the currency leakage pattern, we estimate an outflow of Rs 2 lakh crore to Rs 2.5 lakh crore in the second half of FY24. In case we get no further balance of payment inflows, this implies that liquidity conditions will naturally tighten significantly. Hence, the quantum of OMO sales is likely to be limited, in our view.

The need to keep overnight rates at MSF is driven by a surge in inflation pressures in Q2, led by a spike in vegetable prices. As per the RBI’s inflation trajectory, inflation measured by the Consumer Price Index is expected to average 6.4 percent in Q2, above the RBI’s upper threshold of 6 percent.

Better transmission

Given the temporary nature of vegetable-led price spikes, inflation is expected to moderate in H2, but remain above the 4 percent mark. Indeed, the RBI trajectory shows inflation is expected to move towards 4 percent only from Q2 of FY25.

Hence, the policy stance has been retained as a withdrawal of accommodation, though liquidity conditions have tightened. The tight liquidity conditions will enable better transmission of past policy rate hikes of 250 bps, which remains incomplete, in the RBI’s assessment. The stance indicates that the policy focus remains on keeping liquidity conditions tight so that overnight rates remain closer to MSF. The stance is unlikely to change any time soon, with inflation remaining above the 4 percent target.

The India and US Treasury (UST) yield differential has reduced significantly compared to historical standards. This reflects a relatively more aggressive pace of rate hikes by the US Federal Reserve and a surge in US government debt.

Moreover, the announcement of India’s inclusion in a global bond index from next year has limited the rise in G-Sec yields despite adverse global macros.

In case the RBI does conduct OMO sales, then G-Sec yields could rise to 7.45 percent in the near term, supporting the yield differential.