There was significant turnover in Indian markets with shorter-term Indian bond yields peaking after a surprise announcement from the Reserve Bank of India. The central bank announced late Friday that it is closing a special dollar deposit window for overseas residents earlier than planned, a month before its usual deadline.

The change of course surprised traders as Reserve Bank of India Governor Sanjay Malhotra had earlier in the challenging Aug. 5 policy meeting categorically stated that he did not intend to close the facility early.

Impact on liquidity and market reaction

The sudden news was met with immediate reaction; Indian government bonds dropped, with the shorter tenor bonds taking the brunt of the pain. The five-year sovereign yield increased by up to nine basis points to 6.44%, while the benchmark 10-year paper yield also increased by four basis points to 6.80%. 

This increment in yields effectively reversed a previously ongoing rally in the market that had been driven by shorter-maturity bonds. That earlier rally was the result of the majority of the rupee liquidity provided from the foreign exchange swap facility being absorbed directly through near-term assets, which had further enhanced the steepening of the yield curve. 

The reaction of the market reflects the degree of attention paid to liquidity injection via the foreign exchange swap window. Experts in the market explained that the selling pressure observed by the traders is a direct reaction to the lower expectations for future liquidity in the Banking system.

The special dollar deposit facility has already been widely popular and has attracted more than $50 billion in deposits. This facility will now officially be closed from the end of August following the new timelines. Two related facilities for state-owned enterprises and banks have been put in place and will continue to be operated until December.

Foreign exchange reserves and market implications

The significant dollar inflows achieved under the special scheme certainly helped remove the pressures on the foreign exchange reserves of the central bank. In the past three weeks, foreign exchange inflows brought in more than $30 billion worth to the central reserve stockpile. The central bank’s total foreign exchange reserves now stand at $707 billion, due to these massive deposits.

The move to close the window for dollar deposits earlier than usual will be a limiting factor for the central bank’s ability to provide further support to the Indian rupee despite this strong reserve buffer. Financial firm Citigroup Inc. said the recent run of currency strength is likely to be over in the near future. The bank’s analysts had projected that any upward movement of the rupee would be capped at 95 against the dollar. 

The domestic unit settled 0.2% lower at 95.58 per dollar, trailing Asian currency peers. In response to the early-closed announcement, the U.S. bank revised its projected total gross inflows into the facility to $70 billion, down from the previous estimate of $80 billion. As the RBI now has more resources to limit excessive currency volatility, attention has moved from the randomly noisy marketplace to the general behaviour of the market among investors.

Conclusion

The new special deposit scheme for overseas resident customers has been sharply curtailed, reflecting an important change in the central bank’s approach to policy implementation. The Reserve Bank of India, by closing the facility ahead of a month, has changed the liquidity dynamics of the market.

This has led to an immediate shift in the yields of shorter tenors, and the introduced rupee appreciation path restrictions have highlighted the liquidity-sensitive nature of Indian markets. With foreign exchange reserves comfortably remaining at $707 billion, market participants will need to adjust their expectations on currency flow, banking liquidity, and yield performance.