India’s Best EM Bonds Jolted

Indian sovereign bonds slumped on concern demand for debt will wane after the central bank announced steps to drain funds from the financial system.

The Reserve Bank of India told lenders to set aside more deposits as reserves as the government’s Nov. 8 move to ban high-denomination currency notes saw citizens rushing to banks to submit or exchange the old bills, flooding them with excess cash. That risked prompting a slide in borrowing costs, threatening to hurt financial stability and stoke inflation in Asia’s third-largest economy, Bloomberg reported.

The yield on government notes due September 2026 jumped eight basis points to 6.31% in Mumbai, according to prices from the RBI’s trading system. It is still down 48 basis points in November and fell last week to the lowest level for a benchmark 10-year security since April 2009. Indian sovereign bonds have returned 6.5% in the past three months, the best performance among emerging markets globally, indexes compiled by Bloomberg show.

“The RBI didn’t want to lose control over the price of the money as surging deposits led to short-term rates falling below the benchmark reverse repurchase rate,” said Vivek Rajpal, an interest-rates strategist at Nomura Holdings Inc. in Singapore. “The bearish sentiment for bonds may last for a few days.”

The RBI’s weekend move is expected to suck out about 3.5 trillion rupees ($51 billion) from the banking system, according to estimates from the monetary authority. Prime Minister Narendra Modi’s shock currency ban also risked creating a shortage of bonds the central bank needed to manage its money-market operations.

“The magnitude of surplus liquidity available with the banking system is expected to increase further in the fortnights ahead,” according to the RBI’s Nov. 26 statement. “In view of this, it has been decided to absorb a part of this surplus liquidity by applying an incremental cash reserve ratio as a purely temporary measure.”

The RBI will review the incremental CRR increase once the government issues an adequate quantity of market stabilization scheme bonds as it has promised, Governor Urjit Patel told the Press Trust of India in an interview.

India’s rupee weakened 0.2% to 68.60 per dollar in Mumbai, according to prices from local banks compiled by Bloomberg. It sank to a record low last week.