Faced with multiple challenges on inflation, rupee, growth, and liquidity, the RBI’s Monetary Policy Committee — set to announce its policy on Friday — finds itself in an unenviable position.

On the one hand, the RBI’s continual intervention in the forex market (buying of dollars) has increased the supply of rupee liquidity, throwing up concerns over rise in inflation which is already a pain point.

Then there is the issue of managing bond market expectations in view of the government’s large borrowing programme this fiscal. While the RBI, until recently, managed to cap long term bond yields through operation twists (essentially a liquidity neutral move involving buying of long-term government paper from proceeds of sale of short-term securities), outright open market operations (OMOs) — purchase of central and state government bonds — over the past two months have increased the liquidity in the system, heightening inflation concerns.

The liquidity glut has also led to short term bond rates fall below the reverse repo rate of 3.35 per cent which is distorting the market. Unconventional and loose monetary and fiscal policies across the globe has only exacerbated the conundrum for the RBI.

So what will the RBI do in the upcoming policy? While there is near consensus on the RBI leaving the repo rate (at 4 per cent) and its accommodative stance unchanged, all eyes are on the central bank’s stance on excess liquidity and its forecast on inflation and growth for the current fiscal.

Liquidity glut

The RBI has undertaken a slew of measures post the pandemic outbreak to infuse liquidity into the system — reduction in cash reserve ratio, long term repo operations (LTRO)/targeted TLRO, open market operations, etc. But the RBI buying dollars has been a major driver for surplus liquidity.

Average daily net absorptions under the liquidity adjustment facility (LAF) have been at about ₹4.3-lakh crore so far in FY21 (upto November 22). About ₹2.2-lakh crore (net) has been injected through OMO purchases so far.

Add to this, foreign inflows have been strong and are likely to continue, thanks to the easy fiscal and monetary policies across advanced economies. The Indian equity market has seen a net foreign inflow of nearly ₹1.7-lakh crore this fiscal. In a bid to prevent the rupee from appreciating, the RBI has been buying dollars since April this year. Its foreign currency assets have risen to $533 billion as of November 22, from about $439 billion in April — an increase of about $93 billion. This has only accentuated the surplus liquidity situation. Continual foreign flows and the RBI’s intervention in the forex market will keep the system in a liquidity glut.

Collapse of bond yields

The surplus liquidity has led to a steep fall in short term interest rates. In fact, most of the rates are even below the prevailing reverse repo rate of 3.35 per cent. According to the RBI’s latest data, the weighted average call money rate is currently at about 3.1 per cent.

The yield on 3-month government T-bill that has been trading below the reverse repo over the past few months, had moved below 3 per cent since mid-November. It has inched up to 3 per cent levels only in the past few days. The 6-month T-bill also continues to trade below the reverse repo.

All of this has led to distortion in the short term rates.

Depositors are already feeling the heat, grappling with negative real returns on their deposits. Currently public sector banks are offering about 5-5.25 per cent on 3-5 year deposits. With inflation raging above the 7 per cent mark, further deposit rate cuts (triggered by surplus liquidity and low bond yields) will only pinch depositors more.

On the other hand, while the RBI has been able to keep the 10-year G-Sec yield below the 6 per cent mark through its liquidity measures, operation twists and the recent outright OMOs, it still is about 190 bps above the repo rate of 4 per cent. The reason for such high term premiums is the lingering concerns over the government’s borrowing programme and high inflation.

Here is where RBI’s faces yet another dilemma.

Large government borrowing

The biggest overhang for bond markets has been likelihood of oversupply of government bonds owing to the Centre’s increased borrowings. While the Centre has retained its borrowings at ₹12-lakh crore for FY21, some expect that there will be an increase of ₹2-2.5 lakh crore of borrowings towards the end of the fiscal.

State borrowings, which are at about ₹4.7-lakh crore (gross upto November 20) already, are likely to increase substantially in the fourth quarter of this fiscal. Overall, Central and State government borrowings are expected to be about ₹20-lakh crore in FY21 — up from about ₹13-lakh crore in FY20.

To ease bond market worries, the RBI has been managing long-term government bond yields through operation twist. To further ease the upward pressure on bond yields, the RBI stepped up the outright OMOs (purchase of government bonds) and also announced OMOs for the first time for State Developments Loans (SDLs) as a special case.

While this has helped rein in long term bond yields, it has created an additional liquidity problem. While operation twist is liquidity neutral, an outright OMO purchase increases domestic liquidity. Hence how the RBI will address the surplus liquidity situation without upsetting the bond market needs to be seen.

Revised estimates

The CPI inflation has been above the RBI’s comfort level of 6 per cent for several months now. With the October reading at an unsettling 7.6 per cent, inflation worries are far from receding. The RBI in its previous policy had estimated inflation to gradually ease over Q3 and Q4. It had projected the inflation to average at about 5.9-6.2 per cent for FY21. The RBI is likely to revise this forecast upward in the upcoming policy.

As far as growth is concerned, the RBI had estimated a contraction of 9.5 per cent in real GDP growth in FY21. But after a 23.9 per cent decline in Q1, real GDP contracted by 7.5 per cent in Q2, surprising market and economists positively (expecting much steeper contraction). Whether the RBI revises its FY21 GDP forecast upward, needs to be seen.

In any case, both actual inflation and growth trends moving above RBI’s earlier estimates, only confirms its pause (on rate action) in the upcoming policy.