A few things the RBI should be mindful of before issuing own bonds

Another discretionary tool to manage liquidity may be a timely one

In view of the huge liquidity inflows into Indian markets, authors of the Report on Currency and Finance (RCF) that was published by Reserve Bank of India last week have an interesting proposal to manage the influx. RBI should be able to issue its own bonds to mop up the excess liquidity, the report argued.
 

Globally this is not new, as many global central banks like those in Switzerland, Japan and Sweden issued their own bonds to absorb liquidity in the aftermath of the global financial crisis.
 

Among emerging market economies, Bank of Indonesia pioneered the use of central bank securities even before the Asian financial crisis of 1997, the recent report on currency and finance which was published by RBI last week, observed.
 

“In the absence of budgetary allocations of marketable securities for the conduct of monetary policy in an open economy context, lessons can be drawn from the practice of several central banks that issue their own securities to effectively pursue goals set for monetary policy in the face of large autonomous increase in surplus liquidity due to capital flows,” the report said. RBI makes the disclaimer that the views are those of the authors of the report working in different departments of the central bank and not the views of the central bank.
 

However, there are a few issues that the central bank should be mindful of, before issuing these bonds.
 

Since the thinking is that such bonds would be a replacement of the bonds issued under Market Stabilization Scheme, it is likely that these will be of shorter tenure. In that case, that would be an issue of oversupply of shorter tenure bonds which could push up the yields.
 

“I don’t see the need for such bonds. The idea is, RBI may have to do this if they run out of securities for reverse repo. RBI’s own security is essentially an alternative to MSS, but with RBI having full control over issuance quantum. But whether it’s MSS or RBI’s own bonds they will act as competition to short end borrowing by govt and push up yields,” said A Prasanna, head-Fixed Income Research at ICICI Securities PD.
 

Instead of issuing its own bonds, RBI should actually use the Standing Deposit Facility to mop up liquidity.
 

“The SDF (standing deposit facility), which is available to the RBI is also a sterilisation tool. Under SDF, RBI can take money from banks without giving any collateral. It is less complicated and my view is that SDF should be the first option,” Prasanna added.
 

There is a cost angle also. Since these bonds are issued by RBI, the central bank has to bear the cost. If RBI’s cost increases it will have an impact on its dividend pay out to the government.
 

On the other hand, there is also a thinking that another discretionary tool in the central bank’s armoury is welcome at a time when liquidity management is the need of the hour.
 

“The RBI highlighting the need for greater discretionary access to liquidity management tools is very timely," said Suyash Choudhury, head, Fixed Income, IDFC Asset Management Company.
 

“As it notes, the precautionary building up of forex reserves is a public good even as it may render challenges for the conduct of domestic monetary policy. This can be somewhat mitigated, and the central bank can exercise better control over liquidity and the setting of short term rates, if either it has access to unconstrained issuances on MSS bonds or it could issue its own securities,” Choudhury told Business Standard. MSS or market stabilisation scheme is a monetary policy tool that is used by RBI to manage liquidity. MSS bonds which are mostly of shorter tenure are floated by RBI on behalf of the government to mop up excess liquidity.
 

“It is not a bad idea. They have also mentioned other countries doing it,” said Madhavi Arora, lead economist, Emkay Global.
 

“If they are envisaging that global dynamics are changing in a fashion that they probably need more policy tools to have an integrated policy approach, this could be one of the tools in their kitty. It also gives somewhat independence to RBI to reach their own monetary policy targets,” she said.
 

The RBI Act needs to be amended for allowing the central bank to issue its own bonds.
 

“The option of issuance of its own securities by the RBI, currently prohibited under section 19(5) of the RBI Act 1934, may be explored by amending the Act suitably.”
 

RBI issuing its own bond will be relevant for three reasons, Choudhury says.
 

“One, India’s long awaited cyclical recovery that seems to be finally underway will likely attract stronger capital flows in the time ahead. Two, measures like bond index inclusion as well as an ambitious asset sale programme are likely signaling a greater willingness to invite global capital into the country,” he said.
 

The third reason is that since government bonds yields are hardening, the central bank would like to see orderly evolution to the yield curve, which the RBI governor has emphasised in recent times.
 

“Given the very large steepness of the yield curve currently, the RBI will need to modulate the pace of rise in longer term yields even as it tries to gradually bring up the effective policy rate.  This will entail open market purchases of bonds at the mid to long end alongside absorption measures at the short end (of the nature of the “twist” operations being undertaken now),” Choudhury said. Bond yields hardened following the Budget announcement of additional government borrowing of Rs 80,000 crore in February and March of the current financial year.
 

“All of the above strengthen the case for RBI’s suggestions and it will indeed be desirable for these to see the light of day sooner rather than later,” he added.
 

The central bank observed that sterilised intervention is an effective solution to manage the trilemma in India. “Enhancement of sterilisation capacity may be necessary to deal with possible surges in capital flows in future,” the report said while adding activation of standing deposit facility (SDF) to address the security availability constraint of RBI for undertaking sterilisation operations.
 

The report also observed that the emergence of rupee as an international currency appears inevitable.
 

While such a move can lower the cost of cross-border trade, it can also complicate the conduct of monetary policy.
 

“Internationalisation of a currency makes the simultaneous pursuit of exchange rate stability and a domestically oriented monetary policy more challenging, unless supported by large and deep domestic financial markets that could effectively absorb external shocks,” RBI said.
 

In the Indian context, the primary focus of flexible inflation targeting regime on price stability augurs well for further liberalisation of the capital account and internationalisation of the rupee, the report concluded.