A VRRR of Rs 2 lakh crore would be conducted by RBI

On Monday, the Reserve Bank of India may have given the clearest indication yet of its intention to begin a formal normalisation of the exceptional policy accommodation used to protect the economy from the Covid-19 crisis.

While rising domestic inflation and the reversal of ultra-loose policies in advanced economies had put pressure on the RBI to signal a shift away from accommodative policies, the RBI kept interest rates unchanged earlier this month and reiterated that policy support was needed to ensure sustainable economic growth.

However, behind the scenes, the RBI has been actively taking steps to shift money market rates towards the benchmark policy repo rate, rather than the reverse repo rate, which had been actively dictating banks’ overnight cost of funds amid record surplus liquidity in the banking system.

The central bank has taken significant steps toward re-establishing the repo rate as the benchmark overnight cost of funds, despite an apparently benign news release on Monday. And it did so without boosting the reverse repo rate, which would have resulted in immediate headlines.

According to the RBI’s press release, the central bank will hold a three-day variable rate reverse repo auction worth Rs 2 lakh crore on Wednesday from 1:30 to 2:00 pm.

In January 2021, the RBI began draining liquidity using variable-rate reverse repo auctions, however this is the first time the central bank has conducted a 3-day operation rather than a seven-day or fourteen-day auction.

WHAT HAS RBI DONE FOR YOU?

The RBI will effectively raise ultra-short-term rates to within a shade of the prevailing repo rate of 4.00 percent by allowing banks to receive as much as 3.99 percent (the highest allowable cutoff rate for a reverse repo window in the current interest rate framework) for parking three-day funds.

The central bank’s options may have been limited by the fact that recent 14-day VRRR auctions were severely undersubscribed, indicating that banks were wary of storing large amounts of surplus cash for such a lengthy time.

The RBI stated in its most recent monetary policy statement that it plans to make the auction method the major mechanism for liquidity absorption by January.

In fact, this was another another nudge toward higher rates, as the fixed-rate reverse repo window now offers 3.35 percent (the current reverse repo rate), whereas banks can charge the RBI as much as 3.99 percent in an auction.

With the central bank now offering a much shorter-tenure reverse repo window that might theoretically fetch much higher returns, it stands to reason that the weighted average call rate will now drift towards the repo rate, treasury officials said.

The RBI’s declared monetary policy anchor is the weighted average call rate.

“Short-term money market rates will now almost certainly climb towards 3.75-3.80 percent, and soon towards the repo rate,” a trading head at a primary dealership predicted. “Now that the reverse repo rate is set to be increased in February, it won’t make much of a difference.” “One can only speculate as to why it was not completed this month,” he remarked.

The yield on the 10-year benchmark 6.10 percent 2031 paper increased 4 basis points to the psychologically crucial 6.45 percent threshold, indicating market expectations of near-term policy normalization. When yields rise, bond prices fall, and vice versa.

It’s likely that the RBI was compelled to move by the US Federal Reserve’s recent decision to signal higher interest rates and the Bank of England’s unexpected rate hike. The million-dollar question on sovereign bond traders’ minds right now is whether the stealth rises will be followed by a lift-off in the repo rate in February, now that the reverse repo rate has been raised for all practical purposes.