India short-bond rally may fizzle on RBI cash drain, analysts say

The rally in India's short-end bonds has been one of the bigger stories in emerging-market debt this month. Five-year yields have dropped more than 30 basis points to 6.49% since June 5, when the government cut taxes on foreign debt investors. That puts them on track for the biggest monthly decline in over a year.

Analysts at BofA Securities and Bandhan AMC Ltd. expect the rally to stall. The RBI is likely to step up short-term cash withdrawal operations in coming months. Banking system surplus liquidity is seen climbing toward pandemic-era levels of about ₹8 lakh crore ($85 billion). DBS Bank Ltd. expects the RBI to go further, deploying a cash reserve ratio hike as soon as August.

“There isn’t much room for short-end bonds to rally because if you account for the maturity of the RBI’s short dollar forward book and a potential cash reserve ratio hike, you won’t have that much surplus liquidity left in the system,” said Ashhish Vaidya, head of treasury at DBS. The dollar sales the RBI has committed to in coming months reduce rupee liquidity with local banks.

Rajeev Pawar, head of treasury at Ujjivan Small Finance Bank, expects the five-year yield to stabilize around 6.50%. The RBI will use reverse repurchase operations to absorb surplus cash, he said. Those operations withdraw liquidity for a few days at a time.

The foreign inflows that have powered the rally work through a specific channel. When overseas investors buy Indian bonds, they bring in dollars. Banks swap those dollars for rupees, adding to the banking system's cash surplus. The same inflows that push yields lower also create the conditions for the RBI to intervene.

The RBI has kept its benchmark rate unchanged, unlike some regional peers. It has used other tools to support the rupee, including an incentive plan for overseas Indians on bank deposits and a program to boost foreign bond sales by state firms. Those measures could attract as much as $80 billion, according to economists' estimates.

Inflation risks may push the RBI toward tighter policy. Wholesale prices rose 9.68% in May from a year ago. Deutsche Bank economists expect the RBI to raise rates by a quarter point each in October and December.

The banking system cash surplus had fallen to about ₹29,400 crore as of Wednesday, from a high of ₹5.3 lakh crore in April, due to tax-related outflows. It may rise again toward month-end on state spending and the central bank's dividend transfer to the government.

“It will be important to reduce surplus liquidity,” Vaidya said, citing rising inflation risks.

Deutsche Bank economists expect quarter-point hikes each in October and December.