MUMBAI: Indian bonds and banking shares slumped on Monday after the Reserve Bank of India ordered banks to temporarily increase their cash on deposit at the RBI to absorb excess liquidity caused by a government ban on high-denomination notes.
The benchmark 10-year bond yield rose as much as 15 bps at one point, while the overnight call rate surged to 14.4 percent from its 5.90 percent close on Friday.
The Reserve Bank of India had been forced to act, according to traders, after Prime Minister Narendra Modi's shock move on Nov. 8 to abolish 500 and 1,000 rupee notes had sparked a surge in deposits of the old notes at banks.
Lenders, in turn, had plowed this cash into government bonds, sparking a rally in debt markets that analysts had warned could not last once people started withdrawing cash, a particular concern because the rupee had hit a record low last week as emerging market currencies fell.
Analysts also noted the RBI had to act because it was running short of government bonds that it could offer as collateral under its reverse repo arrangements.
The move comes as the RBI's supervision of the massive operation to deal with the abolition of 86 percent of the notes in circulation has come under increased criticism from Modi's political opponents, including formr Prime Minister Manmohan Singh last month.
The RBI has announced a range of measures to ease the pain from its measures, but analysts say the RBI should have planned more effectively, rather than reacting to events.
"They have been doing a good job ironing out the kinks as they become apparent," said Varun Khandelwal, founder of Bullero Capital.
"However, the RBI was definitely behind the curve in failing to expect massive buying of bonds by the banking system. Their circular placing a 100 percent cash reserve requirement (CRR) on fresh deposits should have come on the 8th or 9th November, not on the 26th (of November)."
The RBI said on Saturday that banks would need to transfer 100 percent of the deposits generated between Sept. 16 and Nov. 11 with the RBI, saying it was a temporary measure that would be reviewed on or before Dec. 9.
The move is likely to drain over 3.24 trillion rupees ($47.29 billion) from the banks, according to Reuters estimates.
The RBI will review its decision once the government has issued an adequate amount of market stabilisation scheme bonds to soak up liquidity, Governor Urjit Patel was quoted as telling the Press Trust of India on Sunday, in his first interview since his appointment in August.
Banking shares skidded on Monday, with State Bank of India down 1.5 percent, given that the RBI's requirements would deprive banks of the interest earned on funds deposited with the RBI.
The RBI's action could also cut short a rally in bond markets that has seen the 10-year bond yield fall more than 50 bps to a more than 7-1/2 year low. The yield was last up 7 bps at 6.30 percent.
Emerging market assets have tumbled since Donald Trump's election to president on expectations he will pursue an expansionary fiscal policy that will drive up inflation and lead to higher U.S. interest rates.
The RBI's banknote action comes ahead of its policy review on Dec. 7. Analysts say there is a growing possibility the central bank will cut interest rates by 25 bps given that the abolition of the high-value banknotes is expected to dent the economy by sharply hitting consumer demand.
The RBI had last cut the repo rate in October, and analysts had expected another cut by early 2017 after inflation has continued to decline.
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