It’s a given that the Reserve Bank of India (RBI) will cut its policy rate and it could happen sooner than later. But even that will not help bring down the yield on government bonds as the market is being flooded with oversupply of government securities.
The benchmark 10-year paper yield on Monday rose sharply to 6.48% from its Friday close of 6.17% after stand-in finance minister Pranab Mukherjee’s interim budget pegged the government’s gross market borrowing at Rs3.62 trillion in fiscal 2010. This is the highest amount that the Indian government has ever borrowed from the market in any year to bridge its fiscal deficit.
In the current fiscal year, the government is borrowing Rs2.61 trillion, including the Rs46,000 crore extra borrowing announced last week. In 2007-08, the government had borrowed Rs1.82 trillion. At Rs3.62 trillion in annual borrowing, the government would need to raise on an average Rs30,000 crore every month from the market. Can the banking system carry such a huge burden?
The year-on-year growth in credit for the banking industry has already dropped to 19% from about 30% in the previous few years, but despite that the risk-averse banks will not be too excited to buy bonds as they will lose when yields rise. Bond prices and yields move in opposite directions.
Banks make money when the bond prices rise and yields drop. When the yields rise, banks are also required to provide for mark-to-market (MTM) losses. MTM is an accounting practice of valuing a financial asset by its market value and not the cost at which it is purchased.
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So, the task before RBI is to keep the yields down. And this is possible by active intervention in the bond market. In the first week of January, after the central bank cut both its policy rates—the repo rate, at which it infuses liquidity into the system, and the reverse repo rate, at which it drains liquidity—by one full percentage point each, the yield on the 10-year paper dropped to 4.86%, a historic low. Since then, it has been rising substantially, ignoring the impact of the rate cuts. The repo rate is now 5.5% and the reverse repo rate 4%, but the long-term bond yield is hovering around a level when both policy rates were much higher. Even if RBI now cuts the rate by 50 basis points, it will not bring down the bond yield unless the central bank sends a strong signal to the market that it is prepared to share the burden of such a huge borrowing programme with the banking system. One basis point is one hundredth of a percentage point.
RBI had said last week that it would conduct open market operations (OMOs) to ensure that the government’s additional Rs46,000 crore borrowing programme before 31 March does not face any problem. Through OMOs, the central bank buys or sells government bonds in the market.
RBI plans to buy bonds from the market through auctions beginning 19 February. But only OMOs will not be able to keep the yields down. The Indian central bank needs to find other ways as otherwise the series of rate cuts and release of liquidity in the system through paring banks’ cash reserve ratio (CRR), the portion of deposits kept with RBI, will be meaningless.
Banks and primary dealers that buy and sell government bonds will not be able to satiate the appetite of the government in the market, as they will run huge interest rate risk when yields are moving up. One way of minimizing the interest rate risk, as we had discussed in this column earlier, could be issuing floating rate bonds, or floaters. The yield on a floater is benchmarked to short-term one-year treasury bills and reset every year, providing a hedge against rising interest rates.
Another way could be transferring the bonds bought under the Market Stabilization Scheme (MSS) from RBI’s books to the government. RBI started issuing these bonds in 2004, after Parliament’s approval, to soak extra liquidity from the system arising out of its dollar buying.
Between 2004 and 2007, there was an unending capital flow and the central bank was buying dollars from the market to rein in the runaway appreciation of the rupee as a strong local currency hurts exporters. For every dollar RBI had bought, an equivalent amount of rupees flowed into the system. At the second stage, RBI was absorbing this liquidity through MSS bonds. In the first week of February, the outstanding MSS bonds were to the tune of Rs1.05 trillion and about 80% of them are dated securities, with the rest being short-term treasury bills. RBI has been unwinding these MSS bonds to create liquidity. Instead, it can transfer this directly to the government’s accounts. This will help the government postpone part of its borrowing by a few years. Under the arrangement, MSS bonds are kept with a special account of RBI, and hence does not impact the fiscal deficit of the government. However, the interest paid on it by the government adds to its fiscal deficit.
Finally, the government can also privately place bonds with RBI. Such off-market deals indicate monetization of the government’s fiscal deficit but take the pressure off the system. Under the Fiscal Responsibility and Budget Management (FRBM) Act in force to discipline the government’s fiscal profligacy, RBI cannot print money without Parliament’s nod. The estimated fiscal deficit for 2009 is 6%, double what the FRBM Act stipulates, and for all practical purposes the FRBM Act is in a coma for now. The challenge before RBI is managing the borrowing programme without destroying the market. If it cannot do so, no amount of cuts in interest rates and CRR can prop up the sagging economy.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Comments are welcome at firstname.lastname@example.org