RBI announced big new measures yesterday to shore up liquidity. These include INR 1 lakh crores of OMO purchases over next 2 weeks, and a USD 10 billion 3 year buy/sell swap for the week after. These come on top of large steps taken already including approximately INR 1.4 lakh crores of OMOs and USD 15 billion of buy/sell swaps. The new steps thus constitute the next offensive in RBI’s response function, and exceed in size any market expectation. They are particularly relevant as they signal a decisive break from a presumed earlier approach. We discuss this below:
A Recap of The Recent Liquidity Story
An underlying starting observation here is that there are limits to which an emerging market (EM) central bank can offset imported tightening of financial conditions. Put simply, RBI has been active in forex defense via selling large sizes of dollar. There is accompanying destruction to domestic rupee liquidity that it has been trying to offset via both temporary and permanent measures. Over 2 months starting October 2024 there was almost a INR 4 lakh crore rupee liquidity destruction as per our calculations, largely owing to RBI’s forex interventions but also partly owing to seasonal rise in currency in circulation (CIC) and possibly some bond holding roll-offs in RBI books. The first strong response to this was via the CRR cut in December. RBI has further appreciably stepped up its response during the current quarter, but it has still been a ‘running to stand still’ exercise to some extent, since liquidity drain has also persisted both from forex operations as well as further rise in CIC. As a result, core liquidity is almost zero as per our estimates as at end of February.
RBI Steps Up Further
With outlier items falling off from inflation and a cyclical growth slowdown, the MPC has cut repo rate in February. However, the underlying liquidity conditions thus far are not conducive to broad based transmission even as lenders may have transmitted on loan rates which are externally benchmarked. After the host of steps taken recently, and with RBI being proactive in supplying overnight liquidity, it wasn’t clear as of yesterday what the central bank’s incremental approach could look like: In one scenario, it could have continued to emphasize temporary tools hereon to manage short term liquidity changes over March on account of advance taxes and be reactive rather than proactive to incremental core liquidity destruction. This approach would have seen adhoc permanent tools till RBI dividend solved the core liquidity issue more emphatically in May. However, the central bank has chosen to take charge, proactively supplying core liquidity rather than being reactive later.
Projecting current growth rate on last year’s trends for CIC, approximately INR 1.4 lakh crores drains out of the system between March beginning and early May. Assuming some further modest dollar sales, it is possible that core liquidity is almost close to zero again by middle of May. However, it will then receive a massive boost from RBI dividend to government (market expects around INR 2.5 lakh crores). Further, there is a seasonal reversal in CIC between late May and end September of approximately INR 1 lakh crores, before leakage starts again from October. Thus, core liquidity situation is expected to look comfortably positive from mid / late May. Further if, as we had hoped for in a note done yesterday ( “Redistribution: A Macro And Market Discussion”, dated 5th March 2025), if there is a redistribution of global growth underway (from a very US centric narrative thus far) that continues weakening the dollar and takes the pressure off from INR, then core liquidity surplus can improve even further.
Conclusions And Investor Takeaways
- The measures announced yesterday are far more in size than any market expectation and possibly signal RBI’s intent to sustainably move core liquidity into positive mode. With these steps, and with some help from global triggers, one can look forward to a substantially positive core liquidity environment especially from end May onwards.
- With RBI’s new reaction function clearer, one also has greater confidence that should liquidity conditions not evolve as currently envisaged, further steps will be proactively forthcoming to ensure that rate cut(s) have an enabling underlying environment for transmission.
- While immediate March related seasonality is still keeping money market and front end corporate bond rates elevated, investors have a very clear signal now to take advantage of this opportunity.
- With RBI taking out INR 2.4 lakh crores of bonds, a possible turn to the US exceptionalism trade bringing commercial demand for EM bonds back, further rate cuts ahead, a conservative government fiscal stance, and recent cheapening of bond valuations, duration investors also have a very good entry point in our view, with a requisite investment horizon in place.
Source: RBI and Bandhan Internal Research
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