Rupee, Bond Yields & RBI’s Stability Measures

From trading near the level of 75 against the U.S. dollar in mid-August to now hovering around 73 per dollar, the Indian rupee has appreciated over 2.6% in nearly 10 trading sessions and has emerged among the strongest against its Asian peers.

On the other hand, Indian bond yields fell to their lowest level in over two weeks on Tuesday. The benchmark 10-year bond yield fell below 6% to trading around 5.9%.

Shifting approach

The Reserve Bank of India (RBI) on Monday announced other two tranches of special market operations (OMOs) of ₹10,000 crore each in September along with other measures to ensure liquidity and financing conditions in the economy.

It also signaled that currency appreciation is going to help achieve its goals of managing inflation. In a note announcing the `Measures to Foster Orderly Market Conditions’, it said ‘the recent appreciation of the rupee is working towards containing imported inflationary pressures. The RBI remains vigilant about these developments’.

The central bank has been building up its foreign exchange reserves aggressively in the past few years which in turn hasn’t allowed rupee to appreciate. The central bank’s foreign exchange reserves have soared to a near-record $537.5 billion. Though, persistent forex purchases have contributed towards keeping the liquidity in the banking system in surplus.

The latest statement from RBI marks a shift from its earlier approach of intervening in the foreign exchange market to pushing the rupee which in turn will make import cheaper and therefore control imported inflation.

Understanding OMOs

In order to bring down the cost of borrowing for the government and flatten the yield curve, RBI announced another round of special OMOs.

An open market operation (OMO) is an activity by a central bank to give liquidity in its currency to a bank or a group of banks. The central bank purchases bonds (government securities) from banks, which injects money into the banking system, thus increasing the money supply. It sells bonds to reduce the money supply.

Open market purchases raise bond prices wherein the sales lower bond prices. When the central bank buys bonds, their demand rises, bond prices go up, which in turn reduces its yields as bond prices & their yields share an inverse relationship.

Banks price their retail loans at higher rates owing to high yields on long-term government borrowings. Therefore, lower yields mean lower loan rates.

As the inflation peaked higher, the bond yields began to rise since then. On the whole, RBI’s OMO announcement suggests its favour for lower yields. Such operations in turn help RBI control the rising inflation without hiking interest rates.

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