Daijiworld Media Network - New Delhi
New Delhi, Aug 27: Indian bond traders expect the Reserve Bank of India (RBI) to use longer-duration liquidity management tools to absorb a sharp rise in surplus funds in the banking system as inflation risks increase and the central bank prepares for a possible monetary policy tightening later this year.
Banking-system liquidity has surged after Indian banks raised foreign currency non-resident (FCNR) deposits and swapped the funds with the RBI under a time-bound scheme introduced to support the rupee.
The scheme has attracted around $65 billion between June 5, when it was launched, and August 21. The final tranche of non-resident inflows is expected to be swapped with the RBI before the window closes at the end of August, potentially pushing surplus liquidity even higher.
The banking system's liquidity surplus has averaged more than Rs 3.4 trillion ($36 billion) so far this month. Bond redemptions are also expected to inject more than Rs 630 billion into the system over the next fortnight, potentially taking surplus liquidity above Rs 5 trillion in September.
To manage the growing surplus, the RBI is likely to use a wider range of instruments to withdraw liquidity for longer periods, according to treasury officials.
"It is very likely the RBI will need to use a wider set of tools to avoid overnight rates drifting towards the lower bound," said Abhishek Upadhyay, co-head of research at ICICI Securities Primary Dealership.
Upadhyay said the RBI could conduct three-month variable rate reverse repo (VRRR) auctions with an early-reversal option. It could also use foreign-exchange sell/buy forward swaps of similar maturities to absorb excess funds.
Another option could be an increase in banks' incremental cash reserve ratio (CRR), requiring lenders to keep a larger portion of new deposits as reserves. Currently, the CRR requirement does not apply to FCNR deposits raised under the special window.
The RBI kept its policy interest rates and stance unchanged earlier this month. However, minutes of the monetary policy meeting released last week showed that members of the rate-setting panel discussed the possibility of raising interest rates later in the year amid concerns over inflation.
Liquidity conditions in the banking system influence the cost of short-term borrowing. Tighter liquidity generally accompanies higher policy rates and can encourage banks to pass on monetary tightening to borrowers.
So far, the RBI has relied on short-term VRRR auctions to manage the surplus liquidity generated by FCNR deposits.
Alok Singh, head of treasury at CSB Bank, said there was a greater-than-50 per cent probability that the RBI would introduce longer-duration VRRR operations. However, he said an interim increase in the CRR was likely only if inflation rises to 6 per cent.
The developments come as the central bank seeks to balance excess liquidity in the financial system with emerging inflation risks while keeping short-term market rates aligned with its monetary policy stance.
($1 = Rs 95.4975)