India's domestic liquidity conditions remain tight, in the run-up to next week's Reserve Bank of India's policy review. Persistent intervention to stabilise the currency, capital outflows and slower government spending have left liquidity in a deficit mode since 4Q15. This shortfall was further aggravated by rise in external volatility this month, on the back of USD 1.6bn worth foreign equity outflows. A strong start in debt inflows has also fizzled out in recent sessions. Including yesterday, the USDINR briefly tested past 68.00 at a few occasions. 

The short-term rates are up sharply, reflecting this strain. Overnight call money rates are hovering above the policy rate, while the three-month commercial paper rates are now nearly 100bps above the December2015 average. The central bank also rejected all bids at (91-day) a treasury-bill sale yesterday for a second time this month. This in effect dilutes the impact of the accommodative policy stance and risks slowing policy transmission further. Banks have been slow to pass on changes in the policy rates, while money markets had eased by a bigger margin. However the recent liquidity strain has also pushed up money market rates. Long-term bond yields are also off their back. 

The emergency liquidity window was also accessed in recent sessions, along with a regular dose of repo auctions. The Reserve Bank of India also conducted two tranches of bond purchases through open market operations. Once back in December2015 and more recently, last week, worth INR 100bn each. The initial reaction in rates/ yields to last week's buyback was positive, it proved to be fleeting as participants switched attention to the upcoming government and states' bond issuances (worth 140bn and INR 180bn respectively). 

Conditions are likely to remain in deficit mode as higher government spending might be offset by increased FX intervention if global financial markets remain on tenterhooks. Risks are also that a need to meet the fiscal deficit target might prevent a steep drawdown on the government's cash balances The central bank is expected to provide some relief through additional bond buybacks in the near-term. Calls for more permanent injection of liquidity will gain attention as the policy meeting nears.