On Friday evening, the Reserve Bank of India announced a purchase of Rs 10,000 crore in government bonds via open market operations. The decision was taken keeping in mind the current liquidity conditions and an assessment of ‘durable’ liquidity needs in the future, the central bank said.
It’s true that liquidity conditions have been tightening gradually. Deposit growth has trended below credit growth. Currency in circulation is rising quicker than it was a few months ago. And capital inflows have turned to outflows, which means that the rupee liquidity the RBI was providing by purchasing excess dollars from the market, is no longer forthcoming. It’s this combination of factors that led the RBI to announce a purchase of government bonds, explained Soumyajit Niyogi of India Ratings. He expects the OMO purchases to continue and not be a one-off. The RBI, of course, doesn’t explicitly tell you whether it will continue bond purchases and for how long.
While liquidity has tightened, it is worth noting that the overnight call money market rate has remained anchored close to the policy rate of 6 percent. A few monetary policy meetings ago, when Governor Urjit Patel was asked about tightening liquidity conditions, he cited the rangebound call money rate in rubbishing the bond market concerns on tightening liquidity conditions.
So what has changed now that prompted the RBI to initiate (assuming it’s not a one-off) purchases of government bonds?
The prevailing conditions in the bond markets could be one reason. And if that is the case, it brings back the debate over whether the central bank should be tasked with managing the government’s debt.
Before we get to that debate, a quick summary of what’s been happening in the bond markets.
India’s 10-year bond yield has been moving higher since about September last year. It was about that time when it became clear that the government will miss its initial fiscal deficit target of 3.2 percent of gross domestic product in 2017-18. At about the same time, it started to look like the current monetary policy cycle may be maturing and higher interest rates may not be too far behind.
Since then much has been attempted to calm the bond markets.
The government first tried to make changes at its end.
It told the bond markets that it would cut additional borrowings planned for FY18. It convinced the RBI to shell out an interim dividend of Rs 10,000 crore to ensure that the revised fiscal deficit target of 3.5 percent of GDP is met. It avoided front-loading the borrowing for FY19. It also said the total borrowings for FY19 may be lower than indicated in the budget. Yields fell briefly on each of these announcements but snapped right back.
Then came announcements from the RBI.
Banks were allowed to spread the mark-to-market hit on their treasury portfolios over four quarters. This, despite the fact that a few months ago, in January, RBI deputy governor Viral Acharya has told banks that it is not the central bank’s job to manage the price of any long-term asset, including, presumably, the 10-year bond.
Changes in foreign investment limit and rules for foreign investment in bonds followed.
Now finally, the RBI has brought out its most powerful weapon – bond purchases via open market operations. By adding demand to the bond market, the RBI will likely be able to bring down rates.
The question is, why is the RBI doing this? Does it believe that market rates are moving away from the monetary policy stance? Or is it joining the government in trying to ensure the smooth passage of the borrowing programme (of the centre and states)?
At this point, it seems more like the latter because rates are adjusting to changing fundamentals. The general government fiscal deficit is set to breach 7 percent of GDP this year, Jahangir Aziz, chief emerging markets economist at JPMorgan told BloombergQuint in a recent interview. Rating agency Fitch shares that view. With the fiscal and current account deficits widening, rates will rise and the rupee will weaken, Aziz said.
If anything, the RBI is perhaps standing in the way to a natural adjustment to rates.
In doing so, it is once again preventing the market from doing its job of disciplining borrowers – in this case, the government.
Also, in the current situation, the RBI is trying to compensate for the lack of demand for bonds from public sector banks. But that too is not the RBI’s job. If the government likes, it can provide more capital to banks to ensure that they feel healthier sooner and return to the market.
These conflicts, of course, are not new. Some of these issues have been at the core of the suggestion that the government debt management function be separated from the RBI. Many committees have suggested the formation of an independent debt management office. Some progress was made during the tenure of the former Governor Raghuram Rajan when a ‘middle office’ was set up as an interim solution to setting up a Public Debt Management Agency.
The last we heard about this was in October 2016 when a Public Debt Management Cell was set up.
The cell only had an advisory role to avoid overlaps with the statutory role of the RBI as the government’s debt manager. But the idea was that the PDMC would morph into the PDMA over a period of two years.
Since then little has been heard about the plan. It’s not clear whether the government or the RBI have changed their mind. Or if the plan, to the convenience of all concerned, has been put on the back burner.
It is important, though, to ensure the plan remains on track.
The intrinsic merits of freeing the RBI of government debt management functions have only strengthened after India adopted a flexible inflation targeting framework. By mandate, the Monetary Policy Committee (which is only half made up of RBI officials) must now target inflation. Sure, the mandate is flexible to ensure that monetary policy also takes into account the growth scenario, which is important for an emerging economy like India. But does that mandate allow for the central bank to step in to manage borrowing costs which, as in the current scenario, are being driven by altering economic and supply-demand fundamentals? Perhaps not.
You may also come to a point, fairly soon, where some of these RBI actions taken to manage borrowing costs start to run contrary to a tightening monetary policy stance, decided upon by the Monetary Policy Committee. In such a scenario, the market would be torn between taking direction from the MPC and the RBI.
Such dilemmas could be avoided if the RBI were to shed its government debt management function once and for all. It may mean some pain in the short term but it would bring greater clarity and greater discipline in the long term.
Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.