Managing monetary policy with government bonds

Managing monetary policy with government bonds
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First Published: Mon, Jun 18 2007. 03 32 AM IST
Updated: Mon, Jun 18 2007. 03 32 AM IST
Mumbai: It’s cooling down in Mumbai. India’s financial capital experienced its first monsoon showers last week drastically bringing down the temperature. Financial markets, too, heaved a sigh of relief with normalcy returning to different pockets of the markets. The overnight call money rate—the rate at which banks borrow funds to tide over their temporary asset-liability mismatches—rose to 3.5% last week, from its historic low of one paisa in the beginning of June.
In the bond market, the yield on the 10-year benchmark paper rose to 8.41%, perilously close to the level that it had touched in December 2001, but dropped to 8.28% on Friday. In the currency market, the spectacular rise of the local currency since January has finally been arrested. The rupee slipped and breached the Rs41 level on Friday after hitting a nine-year peak of Rs40.28 to a dollar in late May.
Foreign exchange dealers believe that from now on the local currency will continue to see “corrections”, it will no more remain a one-way movement for the rupee. To top it all, the wholesale price-based inflation rate dipped to a 10-month low of 4.80%, sharply down from 6.7% in January. This is also way below the Reserve Bank of India’s projection of 5% for financial year 2007-08.
Those (including this columnist) who were surprised by the inaction of RBI in draining out the sudden surge of liquidity a fortnight ago, are now convinced about the potency of its new-found tool—stamping out liquidity through bond auctions, instead of hiking banks’ cash reserve ratio (CRR).
In the past two weeks, the central bank has raised Rs40,000 crore through government bonds and treasury bills. It has also raised money outside the government’s scheduled borrowing programme and under the monetary stabilization scheme (MSS), an arrangement between the government and RBI put in place in 2004 to drain excess liquidity.
The signals are very clear: RBI can manage its markets without raising interest rates and CRR.
On 6 June, the European Central Bank, which sets rates for most of Europe, lifted rates by a quarter percentage point to 4% to keep inflation at bay. The Bank of England hiked its rate last month to 5.5%. However, Bank of Japan last week decided to keep its overnight call rate target unchanged at 0.50% after the fifth straight meeting. The vote by its nine-member policy board against any rate hike was unanimous. This is significant since a split vote would have been interpreted as a sign of rate being increased in July. The overnight call rate target, has now been kept steady since February, when the central bank increased it to 0.50% from 0.25 %.
Nobody was actually expecting the Japanese central bank to hike rates even though former Federal Reserve chairman Alan Greenspan predicted an increase in benchmark yields and higher premiums on emerging market debt. “So, I’d suggest someone out there is not going to be as happy as we are today,” Greenspan had said at an event hosted by the Commercial Mortgage Securities Association in New York last week. Greenspan’s comment had its effect on the global bond markets that cooled after Japan’s central bank decided against any rate hike. The US government bond prices staged a rally on Friday, riding on the benign data on core inflation and weak consumer sentiment that somewhat dimmed the prospects of an interest rate hike by the Federal Reserve. The yield on the 10-year treasury bills dropped to 5.15% on Friday, from 5.23 % on Thursday. The yield, which moves in the opposite direction of price, rose to as high as 5.33% early last week, its highest level in past five years, surpassing the Fed rate target for overnight loans between banks for the first time since 28 June, 2006—the day before the US Fed raised the borrowing cost for the 17th straight time pushing it up to 5.25%. The yield on the 10-year Japanese bond also came down 2.5 basis points to 1.930%, off an 11-month high of 1.985% hit early last week.
A surge in bond yields is an indication of the global markets’ increasing sensitivity to the possibility of interest rates rising sooner than later. And India is no exception.
Despite the fall in the inflation rate and relatively slower credit growth (about 26% against 30% in past three years), RBI has possibly still not reached the neutral zone of interest rates. The economy grew by 9.4% in the fiscal year ended in March, its fastest growth rate in past 18 years and industrial production grew an annual 13.6% in April, outstripping forecasts for a 11.4 % rise. No central bank can keep its eyes shut to these numbers. Fundamentally nothing has changed in the Indian economy that warrants for an accommodative monetary policy. What has changed is RBI’s strategy of managing its policy. And that has to some extent killed the fear factor in the market. Bond dealers and bankers are no more counting days for a rate hike or a raise in banks’ CRR.
This is because RBI does not necessarily have to follow the conventional ways to achieve its objective. The past fortnight has shown that even the government borrowing programme can be used as a monetary policy tool!
A few thousand crores of extra borrowing is any day a more clever way of monetary management than tinkering with interest rates and CRR. RBI can also increase the size of the MSS, from its present level of Rs1.1 trillion, to show its aggression in stamping out liquidity from the financial system. RBI deputy governor Rakesh Mohan last week at Bank of France seminar in Paris, made this amply clear when he said the central bank may need to step up open market operations in the government bond market to improve the transmission of monetary policy.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai Bureau Chief of Mint. Please email comments to
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First Published: Mon, Jun 18 2007. 03 32 AM IST
More Topics: Money Matters | Bonds |