RBI must innovate to manage crunch


We are a week away from the Reserve Bank of India’s (RBI) annual monetary policy for fiscal 2013. Two sets of critical data—factory output for February and inflation in March—will be released before the policy, and both have a bearing on its theme. At this point, what is crystal clear is that partial devolvement of the year’s first bond auction is not a happy omen, and the Indian central bank will have a challenging year ahead grappling with tight liquidity and a record government borrowing.
File Photo
RBI auctioned four lots of bonds worth Rs 18,000 crore and there were no takers for about 7% at the cut-off price at which the central bank chose to sell them. They devolved on the primary dealers—those who buy and sell government bonds. According to RBI rules, if a bond auction is undersubscribed, an underwriter needs to subscribe to the remaining shares. Primary dealers play that role. The auction devolved partially and yields on bonds rose steeply despite the fact that RBI bought bonds through its so-called open market operations (OMO) just before the end of fiscal 2012 to infuse liquidity in the system, something the Indian central bank had not done in the past. It bought bonds worth Rs 4,582 crore; the target for the OMO was Rs 10,000 crore. Interestingly, the OMO was announced on 29 March, the day RBI announced the results of state development loans of 15 Indian states. The auctions for these loans were conducted on 27 March.
Quite a few states did not get any money at the auctions. For instance, Bihar (Rs 111 crore), Manipur (Rs 140 crore) and Sikkim (Rs 40 crore) did not get any money. Goa and Jharkhand could manage to get 50% of what they wanted to raise, and Tripura one-third of its need. Jammu and Kashmir had to pay as much as 9.49% for 10-year money, Tripura 9.42%, and West Bengal 9.36%. Indeed, the differential interest rates reflect the relative ratings of the states, but the spread between a central government paper and a state government paper has rarely been so high. On the day the state paper auctions were held (27 March), the yield on 10-year central government paper was 8.51%. This means the spread between the central and state papers was as much as 98 basis points (bps) for one state, and between 80 bps and 90 bps for most others. A basis point is one-hundredth of a percentage point. Typically, the spread between a central and state government paper is 50-60 bps.
The higher spread shows the market’s lack of appetite for government papers. Incidentally, the day the results of the state loan auctions were made public, RBI announced the Rs 10,000 crore OMO. The ostensible reason behind this was to infuse liquidity to ensure the success of the first tranche of Rs 18,000 crore central government bonds. The OMO was announced after market hours on 29 March, and the next day, the yield on the benchmark 10-year paper dropped from 8.59% to 8.54%. Had there been no OMO announcement, the yield would have shot up. By the time the first auction of the year was held on 3 April, the yield rose to 8.76% and went even beyond that the next day. It’s now fairly clear that RBI announced the OMO not only to ensure the success of the first bond auction, but also to protect commercial banks from the so-called mark-to-market losses in their bond portfolio.
Under norms, banks are required to invest 24% of their deposits in government bonds (but many have invested 29% or even more), and a substantial portion of this needs to be valued at their market prices at the fiscal year end and not the cost at which they are bought, in accordance with the accounting practice. For bonds, prices and yields move in opposite directions. So when their yields rise, prices fall, and banks need to make good the erosion in value by setting aside money. By announcing the OMO, RBI artificially suppressed the price of bonds on the last day of March, lessening the banks’ provisions, which would have affected their profits.
There is no harm in allowing the yields to rise as RBI has no mandate to protect banks’ profits, or for that matter cut the government’s cost of market borrowing. An OMO at the year end and ahead of the first bond auction of a fiscal year is an easy way out to manage liquidity and protect banks’ profitability, but this is lazy central banking. RBI needs to find smarter ways to address the problem of tight liquidity.
Round the year, an OMO is an option. It can also start measuring the cash deficit in the system by netting off the government’s cash balance kept with it. In last week of March, banks on an average borrowed Rs 1.6 trillion daily from RBI, while the government’s cash balance with the central bank dropped from around Rs 60,000 crore on 23 March to Rs 49,000 crore on 30 March. This means, the net deficit in the system varied between Rs 1 trillion and Rs 1.2 trillion.
This will take care of the pressure of the so-called frictional liquidity (when there is money in the system but locked with RBI as the government is not spending), but RBI will have to find ways to tackle the structural liquidity issues. For instance, it can experiment with allowing banks to offer triple-A-rated corporate bonds as collateral to draw money from the repo window at 8.5%. Currently, only government bonds can be offered as colletral. When a bank does not have excess bond holdings to offer as collateral, it can raise money up to 1% of its bond holding at a higher price (9.5%) to borrow through the so-called marginal standing facility. This can be raised to 2%. In a challenging year, RBI needs to be innovative.

About the author

Leave a Reply

Your email address will not be published. Required fields are marked *