The spotlight is on the Reserve Bank of India’s assessment of the present liquidity situation when the apex bank announces its next round of bi-monthly monetary policy on Friday — following higher fiscal deficits and borrowings announced in the budget

The six-member monetary policy committee (MPC) of the RBI is also widely expected to leave the policy repo rate unchanged at 4 per cent while retaining an accommodative stance.

The central bank’s views on the current liquidity conditions have gained significance after finance minister Nirmala Sitharaman in the budget put the fiscal deficit for the fiscal at 9.5 per cent of GDP and 6.8 per cent for 2021-22.

She also announced the government would borrow Rs 80,000 crore more in this fiscal taking its total borrowing to Rs 12.8 lakh crore. For the next year, the gross market borrowing is also higher than expected at Rs 12 lakh crore.

Bond market circles fear a higher supply of government paper can lead to rising yields. Yields on the benchmark 10-year bond have risen above 6 per cent since the budget and now stands at 6.07 per cent.

The budget announcement on the high fiscal deficit and borrowings came just days after the RBI had said that it would restore normal liquidity operations. The banking system is flush with liquidity and the lenders have been parking Rs 6-7 lakh crore in RBI’s reverse repo window.

Following the announcement of higher borrowings, markets are waiting to see whether the RBI tweaks its plan to revert to normal liquidity. Analysts at Edelweiss said the RBI not only reverted to a much easier monetary policy during the pandemic by lowering rates and injecting liquidity but also relaxed the liquidity management framework by widening the policy corridor and allowing inter-bank call money rates to slip below the reverse repo rate.

With conditions normalising, the central bank had started the process of restoring the liquidity management framework by announcing a 14-day variable reverse repo auction to push overnight rates back into the corridor, and the effect of this was felt on the 1–5 years segment of the yield curve.

“We will keenly watch the RBI’s commentary or guidance on further normalisation of the liquidity management framework and, more generally, liquidity conditions. As a base case, we do not expect the RBI rushing to withdraw liquidity,’’ a note prepared by Edelweiss said.

“We will watch out for actions such as defined OMO calendar and secondary market G-sec buying, no increase in variable reverse repo quantum and maintenance of adequate system liquidity as strong policy signals’’, a note from Emkay said.

Bond market circles expect the RBI to say that it will come out with open market operations (OMOs) and more Operation Twists to ensure that bond yields do not rise. Some are also of the view that the central bank may announce an OMO calendar. It is also speculated that the central bank may raise the statutory liquidity ratio (SLR) or the percentage of bank deposits that must be invested in Government securities from the current 18 per cent or further raise the held to maturity (HTM) limit. This is a category of banks’ bond investments which do not have to be marked to market with the current rates, thus sparing them from any valuation hits.

"We watch out for actions such as defined OMO calendar and secondary market G-sec buying, no increase in variable reverse repo (VRR)quantum and maintenance of adequate system liquidity –as strong policy signals," a note from Emkay said.

For the MPC there is one relief that retail inflation at 4.59 per cent in December came back to the medium term target of four per cent with a band of +/-2 per cent. This could open up space for the interest rate setting panel in the next fiscal.