Call rate over 10%, yields over 8% next?

The finance minister, the Prime Minister and the Reserve Bank of India (RBI) governor have collectively decided to take government bond yields higher so as to curb volatility in the rupee.

The RBI has announced measures to stem the rupee fall to record low of Rs61.21 to the dollar in intra-day trading last week.

The RBI measures that are aimed at preventing the rupee fall include the following: sucking out liquidity through open market operations (OMO) or sale auction of government bonds; increasing cost of liquidity by hiking marginal standing facility rate to 300 basis points (bps) over repo from 100 bps over repo; and limiting liquidity adjustment facility (LAF) allocation to Rs75,000 crore (around 1% of net demand and time liabilities of banks).

The RBI’s actions will take up overnight money market rates to over 10% as bank borrowing in LAF was over Rs90,000 crore on July 15. The OMO sale auction will drive up bond yields and the 7.16% 2023 government bond will see yields rise to 8% from the current levels of 7.56%.

The RBI’s belief that excess liquidity is causing rupee volatility is completely misguided. The fact that banks are borrowing money from the RBI on a daily basis suggests that liquidity is in deficit. The RBI has theorised that speculators are borrowing the rupee at around repo rates and are buying the dollar to profit from rupee weakness.

The RBI could well have just refused bids for repo than announce measures that will actually cause more debt sales by foreign institutional investors as bond yields rise. The rupee can, in fact, fall further on the back of these measures.