The Bank of England, the Old Lady of Threadneedle Street, was set up in 1694 with a capital of £1.2 million (Rs8.7 crore today) by William Paterson as a commercial bank. The capital was advanced to the government in return for banking privileges, including the right to issue notes up to the amount of its capital. Today, at least three centuries later, it’s once again acting like a commercial bank.
It will start buying investment-grade corporate bonds from banks this week as part of its £75 billion asset purchase plan to spur lending. The objective is to reduce liquidity premiums on high-quality corporate bonds and remove “obstacles to corporate access to capital markets”.
This is part of the government’s so-called quantitative easing strategy to pump money into the financial system and fight recession. The Bank of England started buying commercial paper in February and government bonds last month, sending 10-year bond yields to a record low.
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A relatively younger US Federal Reserve, created in 1913, is also into full-fledged commercial banking. Last week, it announced its intention to buy $300 billion of long-term US treasury securities in the next few months and at least double its mortgage-backed securities purchases to $1.45 trillion to lower loan rates and prop up demand for money. Following this, the 10-year treasury bill yield recorded its biggest drop in 47 years, according to a Bloomberg report.
In addition to the mortgage-backed securities, the Fed is also extending another facility for other securities backed by auto finance, and student, credit-card and small business loans. The Fed wants to ensure that banks have adequate resources for consumers and companies.
Both these central banks have adopted the so-called quantitative easing route to create liquidity and bring down loan rates as they are left with virtually no headroom to lower the policy rates. The Federal Open Markets Committee, the Fed’s policymaking body, last week decided to hold its target for the Federal funds rate, or the rate at which banks lend to each other daily, between zero and 25 basis points. The Bank of England cut interest rates by 50 basis points in the first week of March to a record low of 0.5%. One basis point is one-hundredth of a percentage point.
The Indian central bank doesn’t have too much of flexibility in cutting its policy rates at this point. Unlike other central banks, the Reserve Bank of India, or RBI, has two policy rates—the repurchase, or repo, rate at which it pumps money into the system and the reverse repo rate at which it sucks out money. The repo rate is now 5% and the reverse repo rate 3.5%. The overnight lending rate in the Indian banking system is expected to move within the corridor of repo and reverse repo rates. Since the mandated savings bank rate is 3.5%, RBI can possibly bring down the repo rate below 3.5% only after the savings bank rate is brought down. There is ample liquidity in the system and banks are flush with money. Still, RBI needs to buy government bonds from the market to take care of the government’s huge borrowing programme.
In the beginning of 2008-09, the government had announced an annual gross market borrowing programme of Rs1.45 trillion, but this has gone up to at least Rs2.5 trillion. In March alone, the government is borrowing Rs46,000 crore from the market through auctions. This would have been completed by this time had RBI not cancelled a Rs12,000 crore auction where bidders were betting on higher yields.
RBI has been able to maintain government bond yields at a reasonable level through continuous market intervention. Like any other commercial bank, it has been buying bonds from the market, almost every day, in small quantities. The strategy is not very different from what it does in the foreign exchange market where it sells dollars to meet the demand for the dollar and check the runway depreciation of the local currency. Apart from the daily market intervention, RBI has also been buying bonds through auctions. So far, it has bought at least Rs36,000 crore worth of bonds through the so-called open market purchase, more than what it bought for the government in March.
This is nothing but printing money. The only difference between RBI and Bank of England and the Fed is that unlike the central banks in the UK and the US, the Indian central bank is not announcing in advance how much it will buy from the market. It must do this now as the government borrowing programme in 2009-10 is much larger and the market needs to know RBI’s commitment to buy bonds.
Stand-in finance minister Pranab Mukherjee’s interim budget has pegged the government’s gross market borrowing at Rs3.62 trillion in 2010 and this will go up further as the fiscal deficit is widening. The financial system cannot bear this burden without RBI’s support and instead of continuing with its ad hoc approach it must announce how much it will buy to alleviate the burden on the system.
The Fiscal Responsibility and Budget Management Act does not allow RBI to directly lend to the government. Instead of viewing this as a handicap, RBI should focus on buying bonds from the market as this gives it flexibility in terms of choosing securities and managing the yields. Once Parliament formally suspends the Act and allows the government to privately place bonds, it can open the floodgates and RBI could be forced to meet insatiable demand for money. It’s high time the Indian central bank turned a commercial bank and kept on buying bonds from the market.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as a deputy managing editor of Mint. Comments are welcome at email@example.com