The Reserve Bank of India, or RBI, has called a temporary truce with the bond market by planning to convert Rs45,000 crore of intervention bonds into regular government debt before the fiscal year ends in March. But governor D. Subbarao’s nightmare will begin in April, the start of a fiscal year in which the government will have to borrow more from the market than the deposit increase in the banking system so far this fiscal.
As the government’s investment banker, RBI manages its annual borrowing programme to plug its fiscal deficit, or the gap between the government’s earnings and expenditure. The transfer of the proceeds of these bonds, bought under the so-called Market Stabilization Scheme (MSS), from RBI’s books to the government’s, will ease pressure on the market and may help stabilize bond yields that have been on the rise in anticipation of a glut of debt sales. RBI started issuing these bonds in 2004 to soak up excess liquidity from the system arising out of its intervention in the currency market. Between 2004 and 2007, faced with relentless capital inflows, RBI was buying dollars from the market to check the appreciation of the local currency as a strong rupee hurts exporters. For every greenback RBI bought, an equivalent amount of rupees flowed into the system and this was absorbed through the MSS bonds.
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The transfer of these bonds from RBI’s books to the government’s is one of the many ways through which the central bank has been trying to avoid overburdening the market with bond issues and causing a spike in yields before the fiscal year ends in March. It plans to purchase up to Rs9,000 crore of bonds next week from the secondary market. At the first such open market operation, or OMO, in February, RBI bought Rs5,000 crore.
The reason behind the government’s need for so much money is a growing fiscal deficit, estimated to be 6% of its gross domestic product, or GDP, for fiscal 2009 against an earlier projection of 2.5%. A series of fiscal sops offered by the government contributed to the rising deficit and not all of them were measures to combat the economic slowdown. At the beginning of the year, the government announced an annual gross market borrowing programme of Rs1.45 trillion, but this has gone up to at least Rs2.50 trillion. In the last six weeks of the fiscal, the government needs Rs91,000 crore. While Rs45,000 crore is being raised by converting the MSS bonds into regular bonds, another Rs46,000 crore will come from auctions. At least 12% of a Rs12,000 crore bond auction last week devolved on primary dealers, or PDs, who buy, sell and underwrite such bonds, and another Rs12,000 crore worth of bonds will be auctioned this week.
We may see more devolvements on PDs in March but both Subbarao and his deputy Rakesh Mohan, responsible for managing the government’s borrowing programme, face a nightmare in the next fiscal. Stand-in finance minister Pranab Mukherjee’s interim budget has pegged the government’s gross market borrowing at Rs3.62 trillion in 2010. This will go up by another Rs30,000 crore, following a cut in service tax and excise duty as part of the third fiscal stimulus package. Add to this the borrowings of state governments, which theoretically can raise equivalent to 3.5% of gross state domestic product, or about Rs2.3 trillion from the market. This means, the overall market borrowing by the Centre and states in 2010 could be as much as Rs6 trillion.
Where will the money come from? So far this year, the banking system’s deposit base has grown by Rs4.89 trillion. In 2008, the deposit growth was Rs5.8 trillion and in the previous year, Rs 5.03 trillion. No amount of OMOs by the central bank can help the government borrow so much money from the system. Also, there is a limit to what extent the primary dealers can share the burden. Finally, RBI has exhausted the MSS route. About Rs35,000 crore worth of dated securities are still on RBI books, but they are due for redemption shortly and hence cannot be converted into regular bonds.
Indeed, RBI can allow the foreign institutional investors, or FIIs, a larger play in government debt but that may not be a big booster as these investors don’t even use their current limit of $5 billion. Besides, FIIs normally buy short-term treasury bills and not dated securities as they do not want to take the currency risk. A depreciating local currency kills the benefit of interest income.
The government is also unlikely to tap the overseas market for funds, especially after Standard and Poor’s lowered the outlook on India’s debt to negative last week, putting the country’s rating at the risk of being cut to junk. There had been two proxy sovereign bonds in the past, floated by the State Bank of India, but on both occasions the objective was to raise dollar funds and prop up foreign currency reserves,and not to bridge the fiscal deficit. India now has foreign exchange reserves worth close to $250 billion, much less than the peak of $316 billion in May 2008, but still at a level that lends comfort to the faltering economy.
Subbarao will probably have no choice but to lend directly to the government next year. The Fiscal Responsibility and Budget Management Act does not allow RBI to do this unless both houses of Parliament declare a financial sector emergency. Such an emergency can be declared when the government fails to meet its fiscal deficit target on “grounds of national security or national calamity”. An irresponsible government is not a threat to national security, but is certainly a national calamity.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as a deputy managing editor of Mint. Comments are welcome at firstname.lastname@example.org