The Reserve Bank of India’s announcement on Friday (October 6) to consider the Open Market Operation (OMO) sale of government securities to manage liquidity in the system took the bond market by surprise as the central bank did not reveal any specific timeline for the proposal. In response, the yield on the benchmark 10-year government bonds shot up by 12 basis points to 7.34 per cent as the market anticipates an OMO shortly, which is expected to tighten liquidity in the system.
While there is no explicit calendar for this, a long sword hangs now that such OMOs can be announced any day. “This is especially so since the market understands that the best of liquidity is likely over the October-December quarter. Core liquidity may shrink enough by then for the RBI to not want to persist with OMOs from the next quarter. Thus, the risk of this additional supply is more near term, and this may weigh more on the minds of market participants,” said Suyash Choudhary, Head – Fixed Income, Bandhan AMC.
Though the retail inflation was at 6.83 per cent in August, the market was not expecting this measure from the RBI to suck out excess liquidity, adding a hawkish tint to the monetary policy. Liquidity is expected to tighten due to cash withdrawal from the banking system due to the forthcoming festival season. “Going forward, while remaining nimble, we may have to consider OMO sales to manage liquidity, consistent with the stance of monetary policy. The timing and quantum of such operations will depend on the evolving liquidity conditions,” RBI Governor Shaktikanta Das said while unveiling the monetary policy.
What’s OMO?
The RBI uses Open market operations (OMOs) in order to adjust the rupee liquidity conditions in the market on a durable basis. When the Reserve Bank feels that there is excess liquidity in the market, it resorts to the sale of government securities, thereby sucking out the rupee liquidity. Similarly, when the liquidity conditions are tight, the central bank buys securities from the market, thereby releasing liquidity into the market. It’s used as a tool to rein in inflation and money supply in the system. However, when liquidity is sucked out, it can lead to a spike in bond yields as the RBI will release more government securities into the market and bond buyers demand more interest rate on these securities.
Why RBI wants OMO?
While the specific OMO calendar has not been released, the RBI governor, in the post-policy press conference, emphasized the bank’s intent for “active liquidity management.” This signals the RBI’s inclination towards tighter liquidity conditions in the future, influenced by both inflation risks and financial stability concerns. This stance is in alignment with the central bank’s objective of anchoring inflation at 4 per cent. The RBI’s approach is clear: merely keeping inflation below the upper band of the target range (at 6 per cent) is insufficient, a more proactive approach is essential, according to Amnish Aggarwal, head of research at Prabhudas Lilladher Pvt Ltd.
The central bank wants to use liquidity management to achieve the target. Historically, the October-May period is observed to have high cash withdrawals due to the festive and wedding seasons. This generally tends to reduce the durable liquidity in the banking system, which now appears to be the RBI’s area of focus under liquidity management. Thus, the mention of OMO sale at this stage was a bit of a surprise and it leaves the window open for speculations regarding the level of liquidity at which the RBI may plan out the OMO sale and its quantum, said Pankaj Pathak, Fund Manager- Fixed Income, Quantum AMC.
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What’s the liquidity position now?
The RBI governor hinted that the RBI could opt for an OMO sales auction of government securities to mop up any build-up of excess liquidity. The RBI has been conducting OMO sales in the secondary market over the past month, with net sales amounting to Rs 6,200 crore in September.
The RBI had implemented an incremental cash reserve ratio (I-CRR) in the August MPC meeting, resulting in the withdrawal of liquidity amounting to Rs 1.1 lakh crore from the banking system. Despite the gradual withdrawal of the I-CRR, systemic liquidity continued to stay in the deficit since mid-September due to quarterly tax outflows and GST payments. The advance tax payments have resulted in a rise in the government’s cash balance with the RBI, which is estimated at around Rs 2.7 lakh crore. A pickup in government spending in the second half and the withdrawal of I-CRR can increase systemic liquidity. However, a pickup in currency demand ahead of the festive season can counteract any increase in systemic liquidity, according to Care Ratings.
