What's the impact of MSS on the bond market?

Just what the doctor ordered, says M Pandiarajan, Consultant,Nabard.

The question at this stage is whether the market is ready to receive market stabilisation bonds (MSBs). MSBs are treasury bills and dated securities issued under market stabilisation scheme (MSS) to soak excess money market liquidity stemming from dollar purchases by Reserve Bank of India (RBI).

The market is worried about the liquidity in the system, post-bonds. In the past, whenever the call rates were higher and the liquidity in the system was tight, the RBI had partially accepted the bids under LAF, to ensure sufficient liquidity.

We have also witnessed huge (about Rs 140,000 crore per year), but well-managed government borrowing programmes, completed during the past three years.

Despite the magnitude of these borrowings, there were occasions when market participants queued up before the RBI, even before the office opened, to bid in open market operation sales.

Therefore, the size, timing and tenor of MSBs would also be managed without any liquidity concerns provided RBI maintains stable interest rate. It is also worth noting that MSBs may not necessarily propel yields upwards under such circumstances.

However, there are strong indications that interest rates are unlikely to remain stable. Analysts point out that the economic growth is around the corner, non-food credit is picking up and inflation might descend only to 5 per cent.

In fact, yields started moving up in the five-year segment to 5.10 per cent (February 2004) from 4.90 per cent (December 2003). As yields go up, there will be demand for short-term papers.

MSBs are expected to be of short-term maturity and hence there will be demand for MSBs. The effect of MSBs on the bond market can be seen in light of the supply and demand for government securities.

Government borrowing for the next fiscal year 2004-05 is expected to be lower in the first quarter compared to corresponding period previous year, because of the surplus cash carried forward from this fiscal year.

Hence fresh gilts supply is going to be lower and auctions fewer, at least in the first quarter of 2004-05. Moreover, Rs 49, 353 crore of gilts would mature in March 2004-October 2005.

While the supply of fresh gilts will shrink, provident funds will increase their investment in sovereign paper. Multilateral development banks such as the Asian Development Bank and the International Finance Corporation have been permitted to invest in gilts. And banks "" such as the State Bank of India "" looking to invest in the medium term, display enough appetite for them.

In such an environment, MSBs, which will have all the attributes of the existing treasury bills and dated securities, would be a better alternative for investment in the absence of sufficient supply of government paper.

The average amount parked in daily and 14-day repos is at present over Rs 40, 000 crore. As a fallout, 50 to 75 percent of the gilts auctioned in recent times have been cornered by two or three big players, ostensibly due to lack of better deployment avenues.

This phenomenon could be perceived as one of the factors that contributed to drive down the yield on 10-year paper to below 5 per cent levels. Therefore it is an opportune time for MSBs to arrive. Welcome MSBs.

Another vista for Mint Road

Amit Tandon
Managing Director,
Fitch Ratings India Pvt Ltd

The recent agreement reached by the Reserve Bank of India (RBI) with the government over the market stabilisation scheme (as envisaged by the RBI's working group on instruments of sterilisation) expands the menu of approaches available to the apex bank for management of capital flows.

Seen in the context of other measures taken by the RBI to liberalise capital outflows (including inter alia expanding the automatic route of foreign direct investment, permission to residents to invest abroad up to specified limits etc) and moderate capital inflows, the move to issue market stabilisation bonds (MSBs) draws upon the experience of other countries in managing capital flows through a combination of market-based instruments for sterilisation, liberalisation of capital outflows and control on inflows.

Notably, the People's Bank of China, China's central bank, started sterilising capital flows through issue of central bank bills (an option considered but not recommended by the RBI working group in the Indian context) in 2003. Similar measures for management of capital flows have also been taken in Thailand and Taiwan.

The structure of the market stabilisation scheme takes adequate care to ensure that the proceeds from the issue of MSBs are not used to fund the fiscal deficit.

The amount raised through the issue of MSBs would be credited to a separate fund maintained and operated by the RBI in consultation with the government.

The fund would not be available for regular government expenses.

The issuance of MSBs will considerably augment the RBI's ability to conduct foreign exchange and monetary management operations and help overcome the constraints posed by the depletion in its holdings of government securities.

Importantly, however, as mentioned in the working group's report, the RBI intends to use the MSBs to absorb only the "enduring" component of surplus liquidity and, consequently, the MSBs would complement the normal instruments of day-to-day liquidity management viz the liquidity adjustment facility and normal open market operations.

The central bank will decide and notify the amount, tenure and timing of issuance of such treasury bills and dated securities.

Whenever such securities are issued by the RBI for the purpose of market stabilisation and sterilisation, a press release at the time of issue would indicate such purpose.

The total absorption of liquidity from the system by the RBI will continue to be in line with the monetary policy stance from time to time and accordingly, the liquidity absorption will get apportioned among the instruments of liquidity adjustment facility, market stabilisation scheme and normal open market operations.

Consequently, while tackling surplus liquidity the timing and conduct of stabilisation bond issuances is likely to take into account prospects for credit growth, affirm the current "soft and flexible" policy stance with respect to interest rates and continue with the policy of "smoothening" currency movements as opposed to a more interventionist approach.