By Neha Dasgupta
MUMBAI (Reuters) - Indian traders fear that an interest rate rise from the U.S. Federal Reserve this week could cause a destabilising spike in bond yields, and are calling on the Reserve Bank of India (RBI) to intervene by buying bonds via open market operations (OMO).
Banks are the main buyers of government bonds but are already holding large amounts of them to meet reserve requirements, so their purchases are waning.
At the same time, foreign investors are pulling out of many emerging markets at the moment, so there is less demand from them. Foreign investors have pulled $1.7 billion out of India in November, the highest withdrawals since August.
Indian government bond yields have been stubbornly high and remain close to where they were a year ago, despite the RBI having cut interest rates four times this year. This means its loosening of monetary policy is not producing lower rates.
"The RBI needs to conduct OMOs to provide markets with confidence that the mismatch in demand and supply in government bond markets will be addressed," said Vijay Sharma, senior executive vice-president at primary dealer PNB Gilts Ltd in New Delhi.
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Benchmark 10-year bonds have tumbled over the past two months.
Since hitting a nearly 2-1/2 year low in early October, the yield has surged 27 basis points (bps) to 7.78 percent, even after the RBI eased its key repo rate by a larger-than-expected 50 bps at its policy review on Sept. 29.
The retreat has wiped out most of the gains for the year, and 10-year bond yields are down only 8 bps, even as the RBI has cut the repo rate by a total of 125 bps.
The RBI has a history of intervening in OMOs. In 2013 when Fed taper fears sent the rupee to a record low of 68.85 to the dollar, the RBI bought bonds worth 350 billion rupees ($5.22 billion) from June to August, during the worst months of the market turmoil.
The purchases were intended to ease the rupee shortages caused by frequent interventions.
But that move was under the old management.
New Governor Raghuram Rajan is reluctant to be seen as propping up markets, so the RBI tends to step in only at times of big cash shortages.
Traders said higher U.S. rates could create such a shortage.
Last week, the RBI bought 100 billion rupees in its first large OMO bond purchases since January 2014, and traders hope that is just the start.
The RBI will need to inject a median of 350 billion rupees ($5.24 billion) by March to improve cash conditions and support bond markets, according to a Reuters poll of 11 traders.
Rajan on Friday left the door open for more open market bond purchases, but said the RBI would only do so after considering long-term liquidity needs.
"As and when we get the sense that more long-term liquidity is needed appropriately, we will perhaps do an open market purchase of securities. But all instruments are available to us and we continue to keep the market plentifully supplied with appropriate amount of liquidity."
($1 = 66.9900 rupees)
(Editing by Rafael Nam & Kim Coghill)