Indias central bank may soon start monetising the countrys bulging fiscal deficit, a move that could help contain a sharp bond market sell-off but would stir doubts about the central banks shaky independence. After taking an array of steps to relieve a government bond market choking on new supply, any outright bond purchases would be aimed at countering an unwanted tightening of monetary policy from soaring long-term interest rates.
If the Reserve Bank of India (RBI) goes ahead with it, it would be the first major emerging economy to do so after similar steps in the past few weeks by the Federal Reserve and the Bank of England where policy rates are already near zero. Monetisation could reduce the incentive to contain government spending, which may widen an already large deficit and lead to rating downgrades. Funding the outgoing governments soaring borrowing needs may embolden any new one to keep borrowing after the upcoming national elections starting next month.
Direct monetisation of the deficit is not allowed by a 2004 law except in exceptional events - a condition some analysts say it now being met due to the need for economic stimulus and the bond markets troubles. "We believe this policy change could occur in the next few weeks because the governments concern on the level and volatility of long-term bond yields has increased," said Sailesh Jha, an economist at Barclays Capital.
Benchmark yields have jumped about 150 basis points this year even as the central bank has slashed rates by the same amount, with the governments huge borrowing needs undercutting the monetary easing and making banks reluctant to cut lending rates.
In the past six weeks the government boosted extra borrowing by 910 billion rupees ($18 billion) before the end of the fiscal year on March 31, and the central bank has helped it secure most of the needed funds.
"No doubt, this is monetisation of the deficit, but these are extraordinary times and the central bank is trying all it can to prevent the sharp rise in yields," said Vineet Malik, head of interest rates at HSBC India. Of the 910 billion rupees, the government has only issued 340 billion of bonds and is set to issue another 120 billion on Thursday.
The RBI has agreed to hand over 450 billion rupees held against bonds issued to soak up funds from previous currency intervention. The RBI has also been buying back bonds from the market even as the government is issuing new debt. The central bank has bought back 366 billion rupees of debt in five auctions since mid-February - more than the government has sold - and will buy back up to 100 billion of bonds later on Wednesday.
Even more worrying for bond investors is the planned record government borrowing of 3.62 trillion rupees in the 2009/10 business year starting in April. The government will announce borrowing in the first half of the new business year on Thursday.
Traders say the central bank could consider following other central banks, such as the Fed and BoE, by outlining the amount of federal debt it would buy over a given a period of time. "The central bank should press its advantage and make a public commitment to support the borrowing plan, by announcing its intent to purchase up to 1 trillion rupees of bonds, the bulk of it in the first half of 2009/10," ICICI Securities economist A. Prasanna said.
"Absent such a dramatic announcement, the bond market will revert to gut wrenching volatility and monetary transmission will remain jammed," he said. Before resorting to direct bond purchases, the RBI seems more likely to absorb any unwanted bonds in auctions by doing whats called a private placement, analysts said.
In a private placement, the central bank takes on bonds not allocated to primary dealers in regular auctions. The last private placement of debt with the RBI was in March 2006. A placement now would save the trouble and disruption of having auctions to buy and sell different debt. "In my opinion they should consider a private placement, as under the current arrangement what you are asking is to give the market a two way price for bonds over a one-day period and the market is extracting a price for it," HSBCs Malik said.
This has led to sharp volatility in the bond market. Earlier this month the curve between one-year and 10-year yields steepened to its highest since 1998 as investors baulked at the huge supply. Adding to investors worries, steps to support the market seem to be ad hoc rather than part of a comprehensive plan.
At its first buyback auction in February, the central bank bought back less than half the amount of bonds it offered to buy. The RBI then met market participants, raised the amounts it offered to buy in subsequent auctions and started buying back more liquid debt. But it has yet to purchase all the debt on offer at an auction.
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