RBI's Bond Buying Constraints and Implications for Indian Fixed Income Markets

The Reserve Bank of India (RBI) has been at the forefront of managing liquidity dynamics in a rate-easing environment, deploying aggressive bond-buying programs and structural policy adjustments to stabilize financial markets. However, these efforts face inherent constraints that could limit their effectiveness in achieving desired outcomes for fixed income markets. This article dissects the RBI’s liquidity management strategies, the challenges it confronts, and the implications for investors navigating India’s evolving monetary landscape.

Liquidity Injections and Policy Transmission

Since 2023, the RBI has injected liquidity through open market operations (OMOs) and cash reserve ratio (CRR) adjustments to offset deficits and support monetary transmission. For instance, in May 2025, the central bank announced a ₹1.25 trillion bond purchase, a move analysts likened to a "de facto rate cut" by lowering interbank lending rates and easing bond yields [2]. These interventions were critical in addressing a liquidity deficit of ₹1.33 trillion in early 2025, prompting a doubling of bond purchases to ₹400 billion in February 2025 [3].

The RBI also signaled a planned 100-basis-point CRR cut by November 2025, expected to inject ₹9.5 trillion into the banking system over six months [2]. Such liquidity surpluses have enabled smoother transmission of repo rate cuts, with the weighted average lending rate (WALR) for fresh loans declining by 71 bps between February and June 2025 [4]. However, the effectiveness of these measures hinges on the ability of banks and markets to absorb the injected liquidity without distorting interest rate dynamics.

Constraints on Bond Buying and Liquidity Absorption

Despite these efforts, the RBI faces significant constraints in its bond-buying activities. Market absorption limits remain a key challenge. For example, in May 2025, the RBI absorbed ₹2.23 trillion in liquidity via the Standing Deposit Facility (SDF) and marginal standing facility (MSF), reflecting the need to counteract inflationary pressures [4]. Yet, large-scale liquidity injections risk creating imbalances if not matched by robust demand from banks and investors.

Fiscal policy alignment further complicates matters. While the RBI has relaxed constraints for foreign portfolio investors (FPIs) in corporate debt markets—removing short-term investment caps and concentration limits in May 2025 [1]—fiscal expansion remains constrained by structural issues like weak private investment and global trade uncertainties [3]. This misalignment limits the full transmission of rate cuts, as growth projections for FY26 remain unchanged despite accommodative monetary policy [3].

Regulatory barriers also persist. The RBI’s preference for variable rate liquidity operations over fixed-rate tools has been criticized for creating uncertainty for banks, which struggle to predict liquidity needs [1]. Additionally, the discontinuation of 14-day variable rate repos in favor of shorter-term instruments has reduced flexibility in managing large, persistent liquidity surpluses [2].

Implications for Fixed Income Markets

The interplay of these constraints shapes the trajectory of India’s fixed income markets. Lower repo rates and surplus liquidity have driven bond yields downward, with 10-year government bond yields projected to fall below 6.25% by late 2025 [4]. This environment has incentivized corporate bond issuance, as companies seek to lock in cheaper borrowing costs [1]. However, the RBI’s shift to a "neutral" policy stance—indicating a pause in further rate cuts—suggests that liquidity will remain supportive but not overly accommodative [3].

For investors, this dynamic underscores the importance of short-to-medium term strategies. High-grade corporate bonds and short-duration instruments are likely to outperform, given their sensitivity to liquidity conditions and yield differentials [3]. Meanwhile, the RBI’s efforts to align with global best practices—such as easing FPI regulations—could enhance market depth and attract foreign capital, further stabilizing bond yields [1].

Conclusion

The RBI’s bond-buying programs and liquidity management strategies are pivotal in navigating a rate-easing environment. However, constraints like market absorption limits, fiscal policy misalignment, and regulatory rigidity pose risks to the effectiveness of these measures. For fixed income investors, understanding these dynamics is crucial to capitalizing on opportunities in a market where policy transmission and liquidity conditions remain in flux.

Source:
[1] RBI eases debt market rules for FPIs - Times of India [https://timesofindia.indiatimes.com/business/india-business/rbi-eases-debt-market-rules-for-fpis/articleshow/121009782.cms]
[2] RBI's commitment to keep sufficient liquidity will facilitate rate cut transmission: Fitch [https://m.economictimes.com/industry/banking/finance/banking/rbis-commitment-to-keep-sufficient-liquidity-will-facilitate-rate-cut-transmission-fitch/articleshow/122557905.cms]
[3] RBI Acknowledges Limitations of Policy Easing [https://m.thewire.in/article/banking/rbi-acknowledges-limitations-of-policy-easing]
[4] Surplus liquidity helps better transmission of rate cuts in bond, credit market, says RBI governor [https://www.moneycontrol.com/banking/surplus-liquidity-helps-better-transmission-of-rate-cuts-in-bond-credit-market-says-rbi-governor-article-13403062.html]