Indian bond yields surged after the Reserve Bank of India announced the early closure of its special dollar deposit window, with shorter-maturity bonds taking the biggest hit as traders reassessed expectations for rupee liquidity.

• The five-year bond yield climbed as much as nine basis points to 6.44%, while the benchmark 10-year yield rose four basis points to 6.80%.
• The dollar deposit facility has attracted more than $50 billion and helped lift India’s foreign exchange reserves by over $30 billion in three weeks to around $707 billion.

The RBI’s decision to close the facility at the end of August, a month earlier than originally scheduled, caught markets by surprise.

The move came shortly after Governor Sanjay Malhotra had ruled out an early closure at the August 5 policy meeting.

Short-Term Bonds Under Pressure

The bond market reaction reflects concerns that the early closure will reduce the amount of rupee liquidity entering the financial system.

The special dollar deposit facility encouraged overseas residents to bring foreign currency into India, with the RBI using the resulting inflows to strengthen its foreign exchange position and inject liquidity into the domestic financial system.

Much of this liquidity had flowed into shorter-maturity bonds, helping drive a rally at the short end of the yield curve. With the facility now closing earlier than expected, traders are adjusting their expectations for how much additional liquidity will reach the market.

“The short end is selling off as inflows through the dollar deposit scheme will stop one month earlier, which will be less than the potential liquidity surplus market was factoring in,” said Gopal Tripathi, Head of Treasury, Jana Small Finance Bank in Mumbai.

The five-year yield rose to 6.44%, while the 10-year benchmark yield increased to 6.80%. The sharper move in shorter-tenor bonds highlights how closely this segment had been linked to expectations of additional liquidity from the RBI’s foreign exchange measures.

The decision also reverses some of the recent gains in shorter-maturity government securities, which had benefited from the large liquidity inflows generated through the facility.

What Does It Mean

The early closure could also influence the outlook for the Indian rupee, although the impact is likely to depend on how markets interpret the RBI’s broader currency strategy.

The facility has already generated more than $50 billion in inflows, contributing to a rise of over $30 billion in India’s foreign exchange reserves in just three weeks. Reserves now stand at around $707 billion, giving the central bank a stronger buffer against external market volatility.

However, ending the dollar deposit window earlier could limit additional support for the rupee. The currency weakened 0.2% to 95.58 against the US dollar on Monday, underperforming other Asian currencies.

Citigroup now expects the rupee’s recent gains to remain capped around 95 per dollar in the near term, compared with its earlier expectation that the currency could strengthen to 94.

“It seems that using the scheme to engineer any sharp appreciation of INR to reduce the undervaluation wasn’t one of the main objectives,” said Samiran Chakraborty, Chief India Economist, Citigroup.

The bank has also reduced its estimate for total gross inflows through the facility to $70 billion, $10 billion below its previous forecast.

The RBI’s move, therefore, has implications beyond the bond market. While the early closure reduces the expected flow of fresh liquidity, the substantial foreign exchange reserves accumulated through the facility give the central bank greater capacity to manage currency volatility.

The next focus for investors will be how the RBI manages liquidity and whether the change affects hedging activity and speculation in the rupee market. Chakraborty said the key question is how the move will influence these market dynamics.

For bond investors, the immediate message is clearer: less-than-expected liquidity could keep pressure on shorter-tenor yields in the near term.