Mumbai: Reserve Bank of India (RBI) is expected to step up its purchases of federal bonds to prevent a potential spike in volatility in coming weeks as the government races to borrow $18 billion to plug a gaping deficit.
Central bank purchases of government debt would also likely curb rising bond yields, which are threatening to undermine official attempts to cushion Asia’s third-largest economy from the worst of the global financial crisis.
The central bank has slashed its lending rate by 350 basis points since October, but Indian banks have been reluctant to follow as higher bond yields are pushing up their funding costs.
Since 10 February, the government has announced it needs an extra Rs910 billion ($18 billion) for this fiscal year ending 31 March, which could put massive pressure on yields.
To mitigate the impact, the government has said Rs450 billion would be raised from non-market sources rather than bond auctions, leaving it to borrow the remaining 460 bilion rupees.
Bond markets expect the RBI to agree in one to two weeks to transfer the Rs450 billion held as Market Stabilisation Scheme (MSS) bonds into government coffers, avoiding the need to tap the market for those funds.
The special bonds were used to soak up rupees when the cental bank intervened in 2007 and 2008 to rein in a stronger rupee.
The central bank has recently been buying back MSS bonds the day before government bond auctions to keep markets fluid.
“Four hundred and sixty billion rupees is already a bad number, Rs910 billion would have been unthinkable to borrow in this market,” said Arvind Sampath, director of rates at Standard Chartered Bank.
“The central bank will have to increasingly step forward to smoothen the borrowing process next year, too,” Sampath said.
But first, the central bank needs to produce a clear roadmap for the market on how it can help plug the budget gap, he added.
“Otherwise, yields will continue to grind higher, defeating the central bank’s monetary easing stance,” he said.
Analysts said the MSS move was an easy solution to fill part of the government’s shortfall, but total funds in the scheme are only around 1 trillion rupees.
The central bank is barred from buying bonds directly from the government in except extraordinary circumstances, and taking such a step would be seen as a huge lapse in fiscal discipline.
As a result, it is largely limited to buying back government bonds from the market to reduce potential market disruptions.
Goldman Sachs expects India’s total federal and state deficit to rise to 10.3% of GDP, among the highest in the world, by the end of 2008/09, from 6.3% last year.
The government’s proposed gross borrowing plan for the current fiscal year has more than doubled to Rs3.1 trillion, and it says more stimulus will be needed to aid the deteriorating economy in 2009/10, echoing government spending trends in other parts of the world which have already fallen into recession.
The RBI bought Rs60 billion of government bonds in a primary auction last week, its first such purchase since 2001. The funds were released on Tuesday, adding to liquidity the day the central bank auctioned Rs120 billion of federal bonds.
Yields on the most-traded 2018 bond hit two-month highs on Tuesday and have risen more than 130 basis points this year, unwinding some of the impact of an aggressive burst of monetary policy easing since October.
“The market has lost confidence on how much more the government is going to borrow and that is leading to a breakdown in the monetary transmission mechanism,” ICICI Securities economist A. Prasanna said, referring to why banks have not fully passed on central bank rate cuts to customers.
Analysts believe bond yields will have to fall by at least 50-75 basis points to prod banks to reduce their lending rates.
“The surge in borrowing will weigh heavily on the bond market, though it does not necessarily mean long-term rates have to rise significantly in the near term. Tactically, the RBI will ensure that the upside on bond yields is capped for now,” Macquarie Research analyst Rajeev Malik said in a recent note.
Further monetary easing via rate cuts or reductions in bank cash reserve requirements, open market operations by the RBI, greater use of MSS bonds for funding the deficit and indications of slowing growth and falling inflation in the next few months are all likely to be bond-friendly, Malik noted.
Prasanna also said the central bank could resort to buying more bonds in open market operations and longer-maturity bonds in the secondary market to curb yields, though activities in the secondary market would not provide as much liquidity.
The central bank bought a net Rs240 billion of federal debt in 2008, compared to net sales of 5.6 billion in 2007. Its bond portfolio is Rs578.8 billion, and the total size of the government bond market is Rs14.67 trillion.
“With this policy choice (the MSS transfer), it appears that authorities are collectively opting for more fiscal spending and easier money instead of much lower sustained inflation of 3-4% 12-18 months out,” UBS economist Philip Wyatt said.
“The limitation to this exercise is a re-acceleration in broad money and higher average consumer inflation further ahead.”