Four Questions Around RBI’s Plan To Support State Borrowings
Laborers transport sacks of produce in the vegetable and cotton wholesale market in Nagpur, India (Photographer Dhiraj Singh/Bloomberg)

Four Questions Around RBI’s Plan To Support State Borrowings


The Reserve Bank of India’s plan to conduct open market operations in state bonds for the first time ever got an ovation from the bond markets, with yields falling in the first auction after the announcement.

On Tuesday, the weekly state bond auction saw 13 states raise Rs 19,250 crore. The weighted average cost of borrowings fell to 6.50%—30 basis points below last year, according to data from CARE Ratings Ltd. The spread charged for 10-year state bonds over central government bonds narrowed to 68 basis points—20 basis points below a week ago.

The drop in borrowing costs was driven by the promise that the RBI will buy state State Development Loans or bonds in the open markets for the first time, providing an additional source of demand for these securities at a time when their supply is set to rise.

While the demand-supply dynamics are relatively easy to understand, the RBI will need to tread tricky ground to set up this newly-introduced facility. Not least because it comes as a time when centre-state relations are frayed due to the debate over GST compensation.

Let’s start with the easier question.

Does It Add Risk To The Central Bank Balance Sheet?

When the RBI buys central government bonds as part of its open market operations, it holds these bonds on its balance sheet with a zero risk-weight assigned to them. Will buying state bonds add an additional element of risk to the central bank’s balance sheet? The answer is no. Under Basel norms, the risk weight assigned to claims issued by state governments is zero. As such, the purchase of state bonds will not add a new element of risk to the central bank’s balance sheet.

How Much State Debt Will The RBI Buy?

This is where it starts getting complex.

The RBI’s decision on how much in central government bonds it decides to buy via open market operations is usually driven by its assessment of the durable liquidity needs of the economy. While the market often perceives that the central bank’s OMO bond purchases are driven by attempts to cool down yields, the central bank will maintain that it is the liquidity needs of the economy that drive these purchases. Ensuring that the government’s borrowing costs remain low is a byproduct of the decision.

If that is the case, what will determine the amount of state bonds that the central bank will buy?

One option is that the RBI determines the total amount of liquidity it wants to add via open market operations and then infuses a part of it via a purchase of state bonds rather than central government bonds. In this scenario, it will be a zero-sum game because while creating room for states to borrow more, the RBI will reduce the space to support central government borrowings. If that results in an increase in central government yields, state borrowing costs, which are benchmarked to central bonds, will rise in any case.

So it would make sense for the RBI to buy state government bonds over and above the liquidity it intends to infuse via central bond purchases.

But if liquidity is not the objective to purchase state bonds, then is it yields? If so, will the RBI use an average historical spread to decide when it intends to jump in with an open market operation? If that’s the approach it takes, it will jump deeper into yield management.

In its statement on Friday, the RBI did admit that pricing is a driving objective and was quick to add that this is a one-off measure.

To improve liquidity and facilitate efficient pricing, it has been decided to conduct open market operations in SDLs as a special case during the current financial year. The OMOs would be conducted for a basket of SDLs comprising securities issued by states.
RBI Statement 

Which State’s Debt Will RBI Buy?

The short statement from the RBI says that “OMOs would be conducted for a basket of SDLs...”.

Does that suggest that the RBI would do a combined purchase of a set of SDLs from different states? That would distort any little differential which may have crept into pricing across different states. Ideally, to keep market signals intact, the RBI should buy state bonds individually.

Either way, the RBI will have to decide the proportion in which it will buy bonds. This could be done either using the share of states in the country’s GDP or it could be done via the share of total state borrowings in the previous year.

How Does The RBI’s OMO Plan Fit Into The GST Tussle?

The RBI is getting into open market operations of state bonds at a time when some states have been given permission to borrow more on account of the shortfall in GST compensation.

The finance ministry said that 21 states have been allowed to raise an additional Rs 78,542 crore through open market borrowings. This is because states who have opted for the first GST compensation scheme offered by the government have been given the nod to raise borrowings by 0.5% of GSDP. The statement suggested that borrowings on account of GST compensation will be via “a special borrowing window, coordinated by the Ministry of Finance.” Action on the special borrowing window being taken separately, the ministry added.

While it is unclear what this special borrowing window is, the government’s expenditure secretary TV Somanathan had earlier told BloombergQuint that the securities issued to bridge the GST compensation gap may be structured differently as they are backed by a specific source of revenue.

If that is the case and these securities are differentiated from regular state bonds, then does it make sense for the RBI to do OMOs in this specific set of securities? This would help ensure demand for these securities and if pricing is more uniform for this set of bonds, it may allow RBI to purchase them as a basket. In this scenario, it ends up providing direct support to GST compensation borrowings which have been pushed on to state balance sheets.

Alternatively, the RBI could just buy regular state bonds and provide indirect support by creating room for investors to buy and hold new state securities.

In either case, the RBI will need to tread carefully to avoid tripping into the recently acrimonious centre-state relations.

This column has been amended to add the additional borrowing permitted for Tamil Nadu. It also reflects the government’s clarification that these additional borrowings are on account of permission granted to some states to raise their borrowing by 0.5% if they accept option-1 of GST compensation suggested by the central government.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.

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