As the Reserve Bank of India (RBI) recalibrates its monetary policy to prioritize controlling inflation over growth, the large government borrowing planned for this fiscal year may be a headache. The additional liquidity created by the large supply of sovereign bonds that will flood the market this fiscal year due to central and state government borrowing can fuel inflation, if not managed well. While some of the measures announced in the monetary policy will contribute to this end, the central bank must take additional measures to ensure that there is sufficient demand for the government securities scheduled for issuance this fiscal year. The RBI is clearly aware of the situation, and this is reflected in its stated intention to withdraw its dovish attitude in a gradual and calibrated manner over several years. The move to suck up excess liquidity has, in fact, already started with ₹5 lakh crore already withdrawn from the system with the expiration of some facilities. The huge government borrowing will put upward pressure on bond yields and drive up interest rates in the economy while increasing the cost of borrowing for the government.
Certain monetary policy measures can help ease the pressure on the government bond market. The increase in the existing hold-to-maturity limit for securities eligible for the statutory liquidity ratio from 22% to 23% of net sight and term commitments and the extension of this derogation to securities acquired during of the exercise also, can prevent the banks from selling these securities, if the yields increase further. The move to introduce the standard 3.75% deposit facility, where banks can lend to RBI without receiving government bonds as collateral, may also increase demand for government securities. G-secs received by banks when parking their funds in the reverse repo window are referred to as SLR securities. If banks switch to the SDF window due to higher rates, they will have to buy bonds in the market to meet their SLR requirement. Improving credit demand – which is showing signs of waking up with growth of 9.6% in the first week of April – may also help to reduce excess liquidity somewhat.
The combined borrowing from the Center and the States, amounting to around ₹22 lakh crore, is too much to be absorbed by the market. Since banks and other investors only have the capacity to absorb about two-thirds of this paper, the central bank will have to conduct regular open market operations to absorb the securities. In addition to this, other tools such as dollar-rupee swaps and Operation Twist might need to be deployed to manage liquidity and returns. The RBI must also accelerate the inclusion of Indian sovereign bonds in global indices. Capital gains tax must be waived for Indian bonds settled on international bond clearing platforms so that money from passive investors in index-tracking funds can come to India and drive demand of G-secs. The Retail Direct platform for retail investors investing in government bonds is to be made more attractive by offering tax relief on interest earned. It is starting to gain traction and may help improve domestic demand in the future.
April 10, 2022