Indian policymakers seem to be sufficiently worried about the liquidity crunch in the domestic money market to make two announcements in quick succession. The Reserve Bank of India (RBI) said on Wednesday that it would buy government bonds for the first time this fiscal through what are known as open market operations. The government said on Thursday that foreign institutional investors will be able to invest an extra $5 billion in government bonds and another $5 billion in corporate bonds.
The money market has been tight for some weeks now. Bank borrowing from the overnight repo window touched Rs 1.27 trillion on 11 November; it has been close to Rs 1 trillion this week as well. This is far more than the Indian central bank needs to maintain to ensure robust monetary transmission. The government bond market has also been on the edge. Yields have inched up, especially after the government said it would borrow Rs 53,000 crore more than its budget estimate. A few recent auctions of government bonds received insipid responses from investors; they devolved on primary dealers.
The money market has become tight at a time when economic growth is already slowing and the Indian central bank has indicated that it is unlikely to push up interest rates any further. Both the open market operations and the invitation for more foreign capital into the domestic bond market come with risks attached.
The purchase of government bonds by the central bank amounts to monetization of the fiscal deficit at a time when inflation is already near double digits. And the attempt to pull more foreign money into the bond market risks attracting arbitrage capital that is playing on the difference between domestic and global interest rates; such capital is useful, but also fickle, and could put stress on the external account in case there is a global shock (the wider berth given to foreign investment in Indian bonds comes soon after the minimum time before such investors can sell local infrastructure bonds was cut from three years to one year).
It could be argued that policymakers have few options right now. The most obvious alternative is not attractive at the moment. RBI cannot buy dollars and sell rupees to add to domestic liquidity, because it will further push down the rupee, and it does not have an adequate balance of payments (BoP) surplus to try this out on a sustained basis. The BoP, or the difference between capital inflows and the current account deficit, was a mere $5.1 billion in the first quarter.
However, what the government and the central bank are doing amounts to a high-risk strategy.
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