The Reserve Bank of India (RBI) will likely have to drain up to $22 billion in excess liquidity from the financial system as surging foreign investments forces the central bank to absorb the dollar inflows and sell rupees to cap gains in the local currency.
Foreign investments into debt and shares have reached a net $31 billion this year, compared with $2.7 billion in sales last year, due to factors including India's low inflation and improving economic growth.
The strong inflows have sent the rupee up nearly seven percent against the dollar and forced the RBI to buy more than $10 billion in the spot market and $10 billion in forwards this year - which has meant an equivalent infusion in rupees.
Those rupee sales have added liquidity into a financial system already flush with cash after a ban on higher-denomination currency in November sparked a surge in bank deposits.
Average daily liquidity has risen to around 3 trillion rupees, well above the RBI's goal of around 1 trillion rupees, according to traders.
That will force the RBI to step up debt sales to remove liquidity and avoid any inflationary impact.
Traders estimate the RBI will need to drain 1 trillion to 1.4 trillion ($15.7 billion to $22 billion) rupees after taking into account factors such as festival-related consumer spending that naturally reduce cash in the system.
How the RBI drains the cash will thus become an impact factor for bond traders, who have benefitted from a rally in debt markets.
"I don't think the RBI's intent is to choke the system of liquidity but also at the same time they don't want to maintain excessive liquidity in the system which could obviously create a pain point from an inflation perspective," said Lakshmi Iyer, chief debt investment officer at Kotak Mahindra Mutual Fund.
The RBI has already drained about 1 trillion rupees via one-year bills under a special market stabilisation scheme (MSS), as well as 300 billion rupees in longer debt through open market sales.
Traders said they hope that will continue, noting staggered sales in bills, combined with daily reverse repo operations and some long-end sales, would be easily absorbable in markets.
The most disruptive fashion would be stepping up open market sales, which tend to focus on longer-ended debt, traders said. That may send yields higher and blunt the impact of the central bank's 25 basis point rate cut in August.
The RBI does not provide a timetable of its special debt sales for the year.
"If RBI drains the cash largely through MSS bonds then markets won't get too much impacted," said Suyash Choudhary, head of fixed income investments at IDFC mutual fund.