The Reserve Bank of India’s Monetary Policy Committee, led by governor Shaktikanta Das, kept the key policy repo rate—the rate at which commercial banks borrow from the RBI—unchanged at 6.5% for the fourth time in a row on Friday.

However, one announcement by Das caught the bond market off guard. He said that the central bank is considering conducting open market operation (OMO) sales of government securities (G-Secs) to mop up excess liquidity—a move aimed at curbing inflation.

G-Secs are tradable debt instruments issued by the government and carry the least risk. These securities are either short term—treasury bills, with maturities of less than a year—or long term—government bonds or dated securities with maturities exceeding one year.

RBI will conduct these bond sales via auctions. However, the central bank did not provide any details on the timeline.

The announcement seems to have triggered a wave of anxiety among investors.

Soon after Das’s presser, yields on the government’s 10-year bonds climbed to 7.30% from its previous closing at 7.21%, marking the biggest single-day rise in over a year.

Despite August’s elevated retail inflation rate of 6.83%, the market did not anticipate this strong-handed approach by the RBI. While markets expected the central bank to introduce anti-liquidity measures as the Incremental Cash Reserve Ratio—wherein banks have to park excess cash with the RBI in times of increased deposits—expired on 7 October, the OMO sale was an unexpected move, said Gopal Tripathi, head of treasury and capital markets at Jana Small Finance Bank.

Before we get into why the move has worried investors, let us understand OMOs.

What are OMOs? This is when the central bank sells or purchases G-Secs in the open market to adjust liquidity conditions. So, when there is excess liquidity in the market, the central bank sells securities.

In contrast, when liquidity conditions are tight, the central bank purchases securities from the market. This injection of funds into the market boosts the cash at hand, making it easier for banks and businesses to continue lending.

Why this measure? In August, RBI had implemented an incremental cash reserve ratio (ICRR) mandate under which banks were asked to keep a 10% reserve on the increase in their deposits between 19 May and 28 July. This measure was put in place after the RBI’s decision to withdraw Rs 2,000 denomination currency notes from circulation. These notes were returned to banks, swelling the deposits at their disposal. So the ICRR—which is in addition to the cash reserve ratio where banks have to keep a percentage of the cash depsits with the RBI—helped absorb surplus liquidity in the banking system.

The implementation of the ICRR resulted in Rs 1.1 lakh crore being withdrawn from the banking system, according to The Indian Express. However, ICRR has now been discontinued in a phased out manner as of Saturday.

After the implementation of the ICCR mandate, there was a liquidity deficit of Rs 34,000 crore in the banking system. But now that the ICRR has been phased out, the impounded funds in the reserve have been released. Gaura Sen Gupta, economist at IDFC First Bank, estimates that the core liquidity is set to rise to Rs 3.3 lakh crore.

Even though the festive season is expected to see a pickup in withdrawals from banks, reducing the cash left at banks’ disposal, Das emphasized that the central bank wants to actively manage liquidity instead of relying on organic factors—a hawkish strategy to have tighter control in the future due to inflation concerns.

“We have identified high inflation as a major risk to macroeconomic stability and sustainable growth,” Das said. This approach also aligns with the central bank’s goal of anchoring inflation at 4%.

So, the OMO auctions of G-secs seems to be a step in this direction.

Implications and concerns: While the RBI’s decision to conduct OMO sales—after the ICRR was phased out—seems like a move to curb inflation, the measure will adversely affect non-banking financial companies. It will substantially raise their cost of capital, according to CNBC TV-18.

Additionally, despite Das’s clarification that the OMO sales is only targeting liquidity and not yield, market participants believe that this could be a move to align domestic yields with global yields.

“OMO is normally not used as a liquidity management tool. It is used to manage the yield curve. It looks like the RBI’s intention is to get the front end down a little bit. And the longer end may go up because of OMO sales,” Vikas Goel, MD and CEO at PNB Gilts Ltd told Business Standard.

When liquidity is reduced, it can cause bond yields to rise. This happens because the central bank releases more government securities into the market than there are buyers. As a result, there is greater supply of such bonds and the few buyers will demand a higher interest rate to buy these bonds. Thus yields will rise.

“The use of the OMO sales tool to manage the liquidity is a big disappointment and has spooked the bond market. This Damocles’ sword hanging over will keep yields higher," VRC Reddy, treasury head at Karur Vysya Bank told Reuters.

The yield differential between 10-year G-Secs in the US and India has reached historically low levels, according to economists and bond dealers. This could be bad news for the Indian rupee’s strength, at a time when the rupee-to-dollar exchange rate is already close to its historical lows.

“OMOs by RBI could help arrest the rate differential from narrowing further," a bond dealer told The Times of India.

For the equity market, Lakshmi Iyer, CEO of investment and strategy at Kotak Alternate Asset Managers, advises caution due to increased borrowing costs. With the bond yields surging, Iyer suggests that “till the time the bond yields or sovereign bond yields stabilize, it's very difficult to see the corporate bond yields come down. And that clearly means that the cost of borrowing is going to remain at elevated levels.”