Summary of this article
RBI bought Rs. 50,000 crore worth of government bonds
Here's how liquidity impacts bond markets
The Reserve Bank of India (RBI) infused Rs. 50,000 crore of liquidity into the banking system yesterday by buying government bonds from the market. This was the first time since May this year that the central bank resorted to buying bonds from the market through an auction to inject liquidity into the system.
RBI Governor Sanjay Malhotra had last week while delivering the monetary policy statement said that the central bank will infuse liquidity into the system to ensure effective transmission of rate cuts done so far. The RBI’s monetary policy committee (MPC) has cut the benchmark repo rate by 125 basis points (bps), bringing it down to 5.25 per cent. Along with yesterday’s bond purchases, the RBI has also announced another tranche of bond purchases through open market operation (OMO) auction which will take place on December 18. Prior to that, on December 15, the RBI will also conduct a dollar-rupee buy-sell swap worth $5 billion.
Meanwhile, the RBI has also said that it will continue conducting fine-tuning operations to maintain optimal liquidity levels. According to the latest data, net liquidity absorbed from the banking system, which is a proxy for the liquidity surplus in the system, stood at Rs. 1.84 lakh crore. This is more than 0.80 per cent of total deposits of banks or their net demand and time liabilities.
Liquidity surplus in the system is expected to reduce slightly over the next few weeks due to advance tax payments and outflows due to Goods and Services Tax (GST) payments. However, the RBI’s continuous support to maintain liquidity in the system for banks to effectively transfer the rate cuts to borrowers is not expected to bring down the liquidity to a deficit, according to market participants.
Conversely, the bond buys are also expected to keep bond yields from rising sharply despite most market participants reducing their bets on further domestic rate cuts.
Liquidity and Bond Prices
Liquidity in the market increases the demand for bonds. When there is more money in circulation within the market, demand for assets typically rises. Similarly, when there is a liquidity crunch in the market, investors tend to demand higher yields for bonds, affecting the yield curve of bonds. Lower liquidity in the system also creates higher volatility in bond prices.
One reason why higher liquidity leads to lower volatility in bond prices is due to easier tradability of bonds. In case investors face a cash crunch, their ability to buy bonds gets limited. In such a scenario, the offer and bid prices or yields will be wider, leading bond prices to move sharply. Higher liquidity makes selling and buying bonds in the market easier, making price discovery of a particular bond easier.
Similarly, higher liquidity in the market also translates to lower borrowing costs for companies as well as financial institutions, such as banks. Investors, especially institutional investors, which make up a major chunk of bond investors willing to buy bonds at lower yields as well, leading to rise in bond prices.
However, market participants say that in the current situation, though there is enough liquidity that the central bank is injecting, due to RBI’s dollar sales in the foreign exchange market to limit fall in rupee, the surplus in the system could fall. Additionally, the rise in bond prices is also limited as markets await other macroeconomic cues, they say.
“Liquidity is important, but right now, though there is enough RBI support, bond yields are rising because further chances of rate cuts are diminished. Also, the US-India trade deal is getting delayed, and though that would lead to growth faltering, rupee volatility is very high so, there is a sharp selling from foreign investors as well,” a bond dealer at a public sector bank who did not wish to be named, said.
