The Rs. 10,000 crore bond-buying programme by the Indian central bank, announced last week, could be the beginning of a much larger open market operation (OMO) that the Reserve Bank of India (RBI) will have to unveil in due course. This, along with the Indian government’s decision to allow higher foreign investment in the domestic debt market, will attempt to serve three purposes: creation of liquidity to see through the government’s record borrowing to bridge its fiscal deficit, bring down the yield on government bonds that will pare the government’s cost of borrowing, and stem the fall of the local currency.
Liquidity in the banking system has been quite tight this month, with banks borrowing on an average about Rs. 84,000 crore from RBI every day. At least on four occasions they have borrowed more than Rs. 1 trillion a day. This is while RBI has committed to keep the system in the deficit mode to the extent of 1% of bank deposits, about Rs.56,500 crore.
Typically, liquidity in the system goes down during the festival season as people tend to withdraw money from banks to spend. The tightness will intensify in mid-December, when India corporations will pay advance income-tax for the current quarter. Going by the trend in corporate profitability, that is being affected by high interest rates and a rise in input costs, Rs. 40,000-45,0000 crore is expected to be drained out of the system as advance tax and this will lead to an around Rs. 1.5 trillion daily deficit in the system. In such a scenario, if RBI does not continue with its OMO, there will be more devolvements in government bond auctions. Already about 26% of the last seven auctions devolved on the primary dealers and the yield on the benchmark 10-year bond in mid-November rose beyond 9%.
The pressure on the yield started building after the government announced an additional Rs. 52,872 crore borrowing from the market in the second half of the fiscal year, raising its borrowing in the fiscal to Rs. 4.7 trillion, the highest ever, and at least 12.5% higher than what was originally envisaged in the budget. The government’s explanation for the rise in borrowing has been a drop in small savings and not a rise in fiscal deficit. When indeed it announces a rise in fiscal deficit, the government may have to borrow even more. The estimated fiscal deficit for the year is 4.6%.
Even though RBI’s official stance has been that the OMO is a liquidity measure and its objective is not to bring down the yield on government bonds, the fact of the matter is the government is distinctly uncomfortable with the rise in the bond yield as this pushes up its cost of borrowing and affects the fiscal deficit. The 10-year bond yield is now trading in the 8.75-8.8% range.
The other way of creating liquidity could have been a cut in the cash reserve ratio (CRR), or the portion of deposits banks keep with RBI, on which they do not earn any interest. Last raised in January 2010, CRR is now 6%. RBI has not done so as a cut in CRR would be interpreted as monetary easing, while OMO is a liquidity-boosting step. RBI could cut CRR sometime around March next year or even earlier when inflation comes down, signalling the reversal in its policy stance.
By allowing more bond-buying by foreign institutional investors (FIIs), the government wants to ensure smooth sailing of its borrowing programme, which is under pressure. But more importantly, it will also ease pressure on the rupee that slumped to a 32-month low against the dollar on Friday, creating panic among companies that rushed to buy dollars to cover import bills.
The local currency closed at 51.34 to the dollar, at least 14% lower than its July high. It is still higher than its life-time low of 52.16 hit in March 2009, but many feel the rupee will record its new low against the dollar soon. RBI spent $845 million selling dollars to iron out volatility in the currency market in September, and must have spent another $2 billion since then, but it has not been very aggressive in stemming the fall of the local currency as its dollar sale squeezes out liquidity. This is not desirable at this juncture, even though it is sitting on $314 billion in foreign exchange reserves.
The government has raised the ceiling for investment by FIIs in corporate and government bonds by $5 billion in each category, taking the overall FII investment in the debt market to $60 billion. However, the effective flow could be $40 billion as out of the $25 billion foreign investment limit in infrastructure debt, for procedural reasons, FIIs are not willing to invest more than $5 billion. Infrastructure debt apart, FIIs can invest $20 billion in corporate bonds and $15 billion in government bonds. Incidentally, last year when the government raised FII investment in sovereign bonds, it stipulated that they could invest in papers maturing in five years or of an even longer tenure. This was to prevent short-term volatility in the debt market. But this time around, there is no such stipulation. In some sense, it shows the desperation to woo foreign money.
In this gloomy scenario, the silver lining is a sharp drop in wholesale price inflation to 10.39% year-on-year for the week ended 5 November, from 11.43% for the previous week. The annual rate of inflation, based on food prices, declined to 10.63% from 11.81% following a dip in the price of items such as cereals, milk and poultry products. Inflation for the non-food articles group, too, was lower at 5.33% against 5.41%. This could be the beginning of the decline in inflation, which RBI has been fighting since January 2010 through a hike in CRR and 13 hikes in its policy rate.