RBI’s Cash Tightening to Spark Recovery in Money-Market Rates

India’s key money-market rates and yields on short-term debt are set to rise after the central bank took its first small step to unwind emergency pandemic measures.

The Reserve Bank of India will aim to drain 2 trillion rupees ($27.3 billion) of banking funds via a 14-day reverse repo operation on Jan. 15, the central bank said in astatement late Friday. This is the first move in a phased normalization of the central bank’s liquidity operations, it said.

There has been growing consensus among traders that the RBI will have to start draining excess cash, as surging liquidity caused money-market rates to drop below the central bank’s interest-rate corridor and distort asset pricing. Quantum Asset Management Ltd. and IDFC Asset Management Ltd. have been among those forecasting that short-end rates will rise faster than the long-end as a result, though nobody expects the central bank to abandon its easy policy.

The announcement is “a clear signal from the central bank that it wants to slowly start the process of exiting from the extraordinary accommodation that remains in place,” said Kaushik Das, chief economist for India at Deutsche Bank AG. “The central bank wants to nudge the various short-term interest rates to converge to the reverse repo rate gradually.”

The RBI assured markets in last week’s statement that it will continue to ensure adequate liquidity. Excess cash in the banking system is currently around 6.7 trillion rupees, according to the Bloomberg Economics India Banking Liquidity Index.

Traders See Cash Tightening in India to Drive Bond Playbook

Yields on one- to three-month bills could rise as much as 15-18 basis points, while those out to one year could climb 10 basis points, according to Madhavi Arora, lead economist at Emkay Global Financial Services Ltd.

The crash in short-term rates raised the risk of distortions in banks’ pricing of assets, and a further steepening of India’s yield curve, which is a concern for policy makers.

After the initial market reaction to the RBI’s statement, attention will turn to Friday’s reverse repo auction. The cut-off rate at which the central bank accepts bids will be a key signal of the interest-rate trajectory, according to a Kotak Mahindra Bank note.

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