RBI to buy Rs 10k cr bonds to inject fresh liquidity

On 16th November, 2011, the RBI announced bond purchases of Rs 10000 cr through open market operations (OMOs). The move came after the stressed liquidity situation in the market and the rising yield of government bonds.  With this, the 10-year bond yield moved southwards. Today, the 10-year bond yield is down by 10 bps to 8.78% after yesterday’s close at 8.88%. The price of the same increased from Rs 99.40 to Rs 100.

The yield of government bonds rises when there are some headwinds in the economy and the government is going through a difficult phase. A good and stable government will generally have low yields. Further, rising yields could make it more difficult for the government to meet its borrowing requirement.

The government has announced that it will borrow an additional Rs 53000 cr in the second half of 2011-12, which will be the source of financing for its fiscal deficit. Of the total budgeted fiscal deficit, an estimate of 66.3% was achieved during April-August 2011. This borrowing will further help the government in meeting its fiscal requirements.  

Over the past, the RBI has continuously raised the repo rate, which helps to suck out excess liquidity from the market. However, the credit growth of the banks has remained above the RBI's projection of 18%.

Banks are consistently borrowing funds under the Liquidity Adjustment Facility (LAF) from the RBI. LAF is a facility extended by the RBI to banks to help them meet their liquidity requirements. Basically, it enables liquidity management on a day-to-day basis. When banks borrow funds from the RBI, there is liquidity injection in the market. For the month of September 2011, approximately Rs 1044050 cr worth of liquidity was injected in the market. With this purchase, the pressure of excess demands of funds from the bank would ease out.

However we fail to understand RBI’s move. On one hand, it is trying to curb inflation by raising interest rates, which results in liquidity being sucked out of the market. On the other, the purchase of the bonds will again create an injection of liquidity, which will further fuel inflation.