A prudent decision by the Centre to retire a part of its debt has led to an unexpected stalemate in the money markets in the last couple of weeks. Earlier this month, with the Lok Sabha elections slowing its spending, the Government of India in consultation with the Reserve Bank of India (RBI) decided to use its idle cash balances to buy back bonds maturing in the next year. This was a well-timed move because, in recent months, banks and other money market participants have been complaining about tight liquidity.

With their credit offtake growing well ahead of deposit accretion, banks have been scrambling for funds. Yet, the two tranches of bond buybacks until Tuesday failed to elicit the expected response. Against the notified target of ₹1 lakh crore, RBI managed to buy back securities worth only ₹12,600 crore. The auctions failed mainly because RBI found the prices being demanded by banks to sell their holdings too high. While RBI has been trying to align cut-off yields in these auctions with its current policy rates, banks were demanding higher prices (or lower yields).

For the Centre this problem is easily solved. It can cancel upcoming bond issues to keep its borrowings at desirable levels. It is the banks that will have a problem. Having shied away from the liquidity lifeline offered by RBI and the government, banks may need to fend for themselves for now. After hiking the repo rate from 4 per cent to 6.5 per cent between May 2022 and April 2023, the Monetary Policy Committee (MPC) has held rates for over a year. However, domestic banks are yet to transmit the full impact of those rate hikes to depositors. RBI data show that the weighted average interest rate on domestic term deposits has moved up by just 181 basis points between May 2022 and March 2024 from 5.07 per cent to 6.88 per cent, though policy rates have climbed by 250 basis points. If a renewed scramble for funds now forces banks to hike their deposit rates further, offering a better deal to household savers, that is just as well.

This episode also highlights a macro challenge faced by RBI — of markets running ahead of policy rate cuts. In the last six months, despite the MPC standing still on the repo rate and staying with a ‘withdrawal of accommodation’ stance, the yield on the 10-year G-sec — the bond market benchmark — has slumped to 7.07 per cent from a high of 7.4 per cent (in October 2023). The influx of foreign portfolio money into Indian bonds ahead of global bond index inclusion in June seems to have fuelled this. Ordinarily, short-term bond yields trade well below the 10-year g-sec on account of term premium. But current yields of 7.07 per cent on 6-month to one-year treasury bills have led to an anomalous flat yield curve, elevating short-term borrowing costs for businesses. This suggests that switching its liquidity stance from ‘withdrawal of accommodation’ to neutral must take priority for the MPC in its next meeting.