Bruising bonds

As the Reserve Bank of India (RBI) recalibrates its monetary policy to give precedence to inflation-control over growth, the large government borrowing scheduled for this fiscal year can be cause for a headache. The additional liquidity created by the large supply of sovereign bonds that will flood the market this fiscal year due to the Central and state government borrowing can stoke inflation, if not managed well. While some of the measures announced in the monetary policy will help towards this end, the central bank needs to take further steps to ensure that there is enough demand for the government securities slated for issuance this fiscal year. The RBI is clearly aware of the situation, and this is reflected in its stated intention to withdraw accommodative stance in a gradual and calibrated manner over several years. The move to suck excess liquidity has, in fact, already begun with ₹5 lakh crore already withdrawn from the system with the lapse of some facilities. The humungous government borrowing will apply upward pressure on bond yields and take interest rates in the economy higher while also increasing the borrowing cost for the government.

Some measures in the monetary policy can help assuage the pressure on the government bond market. The increase in the existing Held To Maturity limit for securities eligible for Statutory Liquidity Ratio from 22 per cent to 23 per cent of net demand and time liabilities and extending this dispensation to securities acquired this fiscal year too, can stop banks from selling these securities, if yields increase further. The move to introduce Standard Deposit Facility at 3.75 per cent where banks can lend to RBI without receiving government bonds as collateral can also enhance the demand for government securities. The G-secs received by banks when parking their funds in the reverse repo window qualifies as SLR securities. If banks move to the SDF window due to higher rates, they will have to buy bonds from the market to meet their SLR requirement. Improvement in credit demand — which is showing signs of awakening from its slumber with 9.6 per cent growth in the first week of April — can also help reduce the liquidity surplus a little.

The combined borrowing of the Centre and the States, amounting to around ₹22 lakh crore is too much to be absorbed by the market. With banks and other investors having the capacity to absorb only about two-thirds of this paper, the central bank will have to regularly conduct open market operations to absorb the securities. Besides this, other tools such as dollar-rupee swaps and Operation Twist may need to be deployed to manage liquidity and yields. The RBI also needs to expedite the inclusion of Indian sovereign bonds in the global indices. Capital gains tax needs to be waived for Indian bonds settled in the international bond clearing platforms so that the passive investors’ money in funds tracking the indices can come to India and boost demand for G-secs. The Retail Direct platform for retail investors investing in government bonds needs to be made more attractive by offering income-tax breaks on interest earned. It is beginning to gain traction and can help improve domestic demand going ahead.

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