Executive Summary

In India, the Monetary Policy Committee (an integral part of RBI) has been using the repo rate to control inflation and maintain price stability. In addition, the RBI has been using money market operations to modulate system liquidity in accordance with the overall monetary policy objectives. While the market participants keep their focus on the benchmark rates, it is more important to understand and assess the liquidity management plan of RBI for better treasury decisions.

During heightened uncertainty around the Covid period, most central banks employed huge liquidity stimulus as a form of policy accommodation. In case of India, core money market liquidity surplus increased from its pre pandemic levels of 2.2% of NDTL in Feb-20 to its peak of 7.7% in Sep-21. With economy showing signs of stabilization, the RBI commenced a gradual monetary policy normalization with core liquidity surplus moderating below the inflationary threshold of 1.5% of NDTL by Feb-23. However, recent autonomous actions like higher than budgeted dividend transfer to the central government (Rs 87,416 Cr) and withdrawal of Rs 2000 banknote from circulation has once again pushed core liquidity surplus towards the inflationary threshold of 1.5% of NDTL in Jun-23.

The question is how will RBI manage the surfeit of liquidity on account of autonomous factors without choking credit disbursal while also upholding of its anti-inflation stance? Like manmade dams, RBI can temporarily impound money market liquidity and release it in a calibrated manner to ensure short term money market rates remain hugged to the policy repo rate.

For bond investors, the initial euphoria with respect to increase in liquidity on account of higher than budgeted RBI dividend and withdrawal of Rs 2000 banknote from circulation has waned. The creation of the Liquidity Dam to suitably mop up headline money market liquidity will ensure yield curve slopes upward as long-term rates reflect fiscal pressures and a cautious monetary policy stance amidst inflation risks. The steady albeit moderate uptrend in 10 yr g-sec yields in the last 2 weeks is an indication in that direction.

Suman Chowdhury
Chief Economist & Head of Research, Acuité Ratings & Research