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The Indian central bank's decision to withdraw its highest denomination currency note from circulation is likely to improve banking system liquidity, bringing down recently elevated short term rates, analysts and bankers said.

The Reserve Bank of India on Friday said that it will start withdrawing 2,000-rupee notes from circulation, although they will remain legal tender. Customers holding these notes can deposit them or exchange them for smaller notes by Sept.30, 2023.

The value of such notes in circulation is 3.6 trillion rupees ($44.02 billion), but not all of this will remain in banks in the form of deposits.

Kotak Institutional Equities estimates that liquidity could improve by around 1 trillion rupees, depending on the behaviour of depositors, while QuantEco Research pegs the potential liquidity impact at 400 billion rupees to 1.1 trillion rupees.

ICICI Securities Primary Dealership estimates the liquidity surplus could increase to 1.5-2 trillion rupees.

India's banking system liquidity surplus has averaged above 600 billion rupees in May.

About 2.5-3 trillion rupees of banking sector liquidity leaks out as currency in circulation each year, wrote Pranjul Bhandari, chief India economist at HSBC. "As such, markets may anticipate some comfort on the liquidity front."

Most economists expects the note withdrawal to be less disruptive for the economy than the 2016 demonetisation.

IMPACT ON RATES

If liquidity surplus improves sharply because of this move, "the weighted average call rate could sustain below the repo rate for the next few weeks," said Raju Sharma, chief investment officer – debt at IDBI Mutual Fund.

The overnight inter-bank rate has remained above the policy repo rate of 6.5%.

Short-term interest rates for government securities, bank bulk deposits and corporate borrowings will also likely ease.

Treasury bill auctions will see good demand in the coming weeks, said Rajeev Pawar, head of treasury at Ujjivan Small Finance Bank.

This would eventually spillover to three-year and five-year bonds and yields of such notes could fall by up to 10 basis points, he said.

"With the liquidity coming in, we do expect bullish bets on Indian government bonds to increase across the curve, especially when inflation has come off and rate cuts are getting priced in," Sharma said.

($1 = 81.7800 Indian rupees)