Indian Bond Market Faces Fresh Pressure as RBI Moves to Drain Excess Liquidity

India’s government bond market is facing a tougher stretch after the Reserve Bank of India moved to pull excess cash out of the banking system, reversing some of the liquidity support that had helped domestic debt weather the recent global bond selloff. 

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The RBI’s plan to withdraw ₹1 trillion through open-market bond sales triggered a sharp rise in yields on Tuesday. The benchmark 10-year government bond yield climbed to 7.08%, while shorter-tenure debt saw an even steeper selloff. 

The change in market mood has been swift. Only a month ago, a large inflow of overseas deposits had left banks flush with cash. Now, with inflation picking up and oil prices adding to price pressures, that surplus has become something the central bank is seeking to contain. 

From record liquidity to a ₹1 trillion withdrawal 

The build-up in cash began after the RBI attracted a record $127 billion from the Indian diaspora through special deposits as part of efforts to strengthen foreign-exchange reserves and support the rupee. 

Those inflows exceeded the central bank’s own estimates and pushed the banking system’s cash surplus to a record of about ₹11 trillion, or $115 billion. 

For the bond market, the extra liquidity initially offered a cushion even as yields in major overseas markets moved to multi-year highs. 

That support is now fading. 

With excess liquidity contributing to easier financial conditions at a time of renewed inflation concerns, the RBI has turned to open-market bond sales. Its initial plan involves draining ₹1 trillion from lenders, and the market is preparing for the possibility of further liquidity-management measures. 

The surplus had also pulled interbank borrowing rates well below the RBI’s policy benchmark, creating a gap between prevailing financial conditions and the central bank’s recent signals on inflation. 

Five-year bonds take the bigger hit 

The pressure has been particularly visible in shorter maturities. 

Five-year government bond yields jumped 21 basis points on Tuesday, their biggest single-day increase since May 2022. The rise was considerably larger than the six-basis-point increase in the 10-year yield. 

The timing of the RBI’s bond sales is another concern for the debt market. The central bank is becoming a seller just as government borrowing for the second half of the financial year begins, adding more supply to a market already absorbing substantial debt issuance. 

Expectations covered in the report indicate that the 10-year yield could climb as high as 7.25% by December 31, potentially taking it beyond its May 2026 peak and to its highest level in three years. 

Another ₹2 trillion of excess liquidity may need to be removed from the banking system, according to an estimate cited in the report. Possible routes include short-term foreign-exchange swaps, Market Stabilization Scheme securities and cash-management bills. 

Inflation adds another complication 

The liquidity shift comes as India’s inflation picture becomes less comfortable. 

Data released on Monday showed inflation accelerated in August and moved closer to the upper end of the RBI’s 2%-6% target range. That has strengthened expectations in the market that monetary policy could also turn tighter. 

Market participants are increasingly factoring in a 25-basis-point increase in the benchmark policy rate at the RBI’s October 7 meeting. 

The pressure is not confined to India. Similar-maturity US Treasury yields reached their highest level since 2007 on Tuesday, adding a difficult global backdrop for domestic bonds. 

Foreign investors cut bond exposure 

Foreign portfolio flows also weakened during the selloff. 

Overseas investors reduced their holdings of index-eligible Indian government bonds by ₹24.7 billion on Tuesday. That followed withdrawals of ₹47.3 billion on Friday, the largest such outflow since April last year. Indian financial markets were closed on Monday. 

The combination of RBI bond sales, heavier government borrowing, firmer inflation and rising overseas yields has therefore changed the conditions facing the domestic debt market. 

A month after abundant liquidity helped shield Indian bonds from turbulence overseas, traders are now dealing with the opposite problem: how quickly that surplus will be withdrawn, and how far yields may have to adjust as the RBI tightens its grip on liquidity.