India’s central bank has added more tools to combat inflation as the country’s entry into the global bond index could potentially lead to increased influxes of money that could drive up prices.
Governor Shaktikanta Das of the Reserve Bank of India announced that the bank may sell bonds to absorb excess liquidity while keeping the policy rate unchanged. This unexpected announcement caused benchmark yields to surge, creating uneasiness in the debt market.
Indranil Pan, the chief economist at Yes Bank Ltd, commented, “Unexpected by all, the RBI announces that OMO sales also become a policy tool for the future in its efforts to suck out liquidity.” Pan also noted the importance of this move in the context of India’s anticipated large foreign exchange flows following its bond index inclusion.
JPMorgan Chase and Co. announced last month that it would include India’s bonds in its emerging market gauge by June. This move could potentially bring in $50 billion from investors, with a fifth of the flows expected by March, according to ICICI Bank Ltd.
These inflows will further challenge the RBI in managing liquidity, especially as it may need to purchase dollars to prevent a significant appreciation of the rupee.
The RBI has been selling dollars to protect the rupee as rising Treasury yields dampen the attractiveness of riskier assets. It may need to adjust its foreign exchange strategy as the currency remains near a record low, with traders citing ongoing central bank support.
The yield on 10-year notes climbed by as much as 15 basis points, the largest increase since August 2022, reaching 7.37%.
Das clarified that the plan to sell bonds is part of the central bank’s liquidity management and is not directly connected to the potential inflows resulting from the index inclusion. Additionally, he stated that the RBI does not target a specific level for the rupee and only intervenes to mitigate volatility.
The RBI has been utilizing its reserves of nearly $600 billion to maintain the stability of the rupee, making it one of the least volatile currencies in emerging markets. So far this year, the rupee has depreciated by 0.6%, reaching 83.2450 against the dollar.
Former deputy governor R. Gandhi stated, “The RBI’s activities may increase even more in the currency market in the short run.” He added, “A sudden jump in inflows will push up RBI’s activities, but it has enough tools to manage the volatility and inflows.”
The RBI’s purchase of dollars injects rupee liquidity, which raises concerns about price pressures. Despite inflation moderating to 6.83% in August, it remains above the RBI’s tolerance level.
Das emphasized that the RBI’s inflation target is 4% and not 2%-6%, stating that inflation continues to pose a significant risk.
The central bank has multiple tools to handle inflows, including reverse repo operations, issuance of sterilization bonds, open market operations (OMO) or OMO bond sales, as well as cash reserve ratio requirements. It can also use forward market intervention to delay liquidity injection to a future date.
Edelweiss Mutual Fund noted in a client note that they expect the RBI to utilize OMO sales to sterilize liquidity only once the foreign inflows in the bond market begin in 2024 and durable liquidity exceeds the RBI’s comfort zone.