RBI likely to step-up for liquidity absorption to tighten monetary policy and rate hikes

New Delhi: Indian government bond traders expect the central bank to absorb an increase in surplus liquidity in the banking system with longer-term tools as it prepares to tighten monetary policy in response to rising inflation risks.

Liquidity in the banking system has increased as Indian banks raised foreign currency non-resident (FCNR) deposits and swapped them with the Reserve Bank of India under a time-limited scheme aimed at supporting the rupee.

Between June 5, when it was first introduced, and August 21, the scheme generated $65 billion in revenue. India's banking-system liquidity surplus has averaged more than 3.4 trillion rupees ($36 billion) so far in August, and it is expected to grow further once the final tranche of non-resident inflows is swapped with the RBI before the window closes at the end of the month.

Bond redemptions are also expected to bring more than 630 billion rupees into the system over the next fortnight, potentially pushing surplus liquidity above 5 trillion rupees in September.

To manage the rising surplus, the RBI is likely to use a variety of tools to withdraw liquidity over longer periods of time, according to six treasury officials.

The Reserve Bank of India kept interest rates unchanged earlier this month, but meeting minutes indicate that members discussed the possibility of raising rates later in the year.

The cost of short-term borrowing is affected by the banking system's liquidity conditions. Tighter conditions are typically associated with higher policy interest rates, prompting banks to pass on monetary tightening. So far, the RBI has held short-term VRRR auctions to manage the excess liquidity created by FCNR deposits.