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Explained | Why RBI is buying bonds worth Rs 20,000 crore and other questions answered – Moneycontrol

The Reserve Bank of India will on February 10 purchase government securities under an open market operation (OMO) for Rs 20,000 crore, the central bank said on February 8 as it looked to calm the bond market.

The announcement saw the bond yields that have jumped in the last few days ease to 6.03 percent from 6.07 percent on February 8.

The banking regulator also said it was committed to ensuring ample liquidity in the system to foster congenial financial conditions. The bank needs to keep the yields in check, so that the government’s borrowing plan can have a smooth going.

The government issues bonds to raise money to meet its expenditure, while the yield is the annual return on a bond. Bond yield and prices move in opposite directions. When yield goes up, the borrowing cost for the government, which is the biggest issuers of bonds, also rises. That is the reason the RBI wants to keep the bond market happy.

Why is the bond market baffled?

The government’s market borrowing target of Rs 12.06 lakh crore for FY22 announced in the Budget was higher than expected. The borrowing programme rattled the bond market as it meant an oversupply of papers.

Though the Reserve Bank Governor Shaktikanta Das assured the markets that the central bank will make sure the government borrowing sails through in an orderly manner, the market wanted a more decisive action. The first casualty was G-sec auction on February 5. Against the planned purchase of Rs 31,000 crore, the RBI accepted bids worth only Rs 190 crore. It was clear that the RBI needed to step in.

Why does the government want to borrow big?

The government wants to shore up the COVID-battered economy and set India back on the growth path but doesn’t have enough funds to back the plan. Tax collections have fallen and disinvestment targets, expected to generate a sizable chunk of funds, have not been met due to COVID, hitting revenue generation.

Why does the government need money?

With the private sector on the sidelines, public spending is the only way forward. The government needs resources to fight the pandemic as also to pay up loans and so on. In the current financial year, the government increased the total borrowings by about 54 percent, or Rs 4.2 lakh crore. Originally, the borrowings for FY 21 were pegged at 7.8 lakh crore against Rs 7.1 lakh crore in the previous year. Subsequently, the fiscal deficit, the difference between the government’s income and expenditure, is projected at 9.5 percent of the GDP in FY 21.

Is the bond market happy after OMO announcement?

Open market operations, or OMOs, are of a recent vintage through which the RBI adjusts the liquidity in the market by selling or purchasing government securities. To suck excess liquidity, it sells securities and if it thinks that liquidity conditions are tight, it buys securities from the market, thereby releasing liquidity into the market.

The RBI announcement on Rs 20,000-crore bond purchase cooled bond yields. The announcement was welcomed by the bond market, with the yields easing to 6.03 percent from the previous close of 6.07 percent. The yields had jumped by 15-17 bps after the government announced its borrowing plan.

“Today’s OMO announcement has given comfort to the bond market. The RBI will have to come with up to Rs 2 lakh crore worth OMOs in the next year,” said Vinay Pai, Head-Fixed Income, Equirus Capital.

Are more OMOs likely?

Yes. The RBI is expected to announce OMOs this fiscal year and in the next as well to manage the cost of large government borrowing at an acceptable level.

Bond dealers said multiple rounds of OMOs are expected, amounting up to Rs 2 lakh crore, until the market finds comfort.

The RBI has already set the path for liquidity normalisation, with the cash reserve ratio being restored to 4 percent in two stages. Treasury dealers expect that more OMOs will be required to prevent the borrowing cost from going up.

“If a significant portion of this happens in the first half, preferably long-dated papers, it will help. If buoyancy in the economy and tax collections improves, market will not be worried about the large government borrowing programme,” Pai said.

Will private sector suffer because of huge government borrowing?

When the government is the biggest borrower, there is always a fear that it will crowd out the private sector. “There is an apprehension in the market. The government’s borrowing programme size is larger than market expectation, especially given that economy seems back on track, private sector borrowing is expected to be back and alongside government borrowing, crowding is going to be there,” said Harihar Krishnamoorthy, Head of Treasury at First Rand Bank.

But not everyone agrees with this view. There is enough liquidity in the market for all, even with high government borrowing.

What is the impact of huge borrowing on interest rates?

When there is an oversupply of papers in the market, typically the price fall and yields shoot. But, with the RBI an active buyer, this is unlikely to happen. Bond yields are likely to remain low at the 6 percent level as the RBI is likely to buy bonds in the market.

The overall interest rates in the banking system will remain low as the central bank has affirmed its accommodative stance repeatedly “as long as necessary” to support the economy.

“The RBI wants to signal that we are here to support and ensure that yields remain in a range,” said Madan Sabnavis, chief economist of CARE Rating. According to Sabnavis, yields are likely to remain low due to RBI’s OMO intervention.

What will be the impact on bank credit growth?

While huge government borrowing is certainly bad news for the private borrowers, the RBI has been using instruments like long-term repo operations (LTROs) and targeted LTROs to ensure banks get enough money to lend to productive sectors. But only big companies with top ratings have largely benefited from the RBI’s liquidity push so far. With the economy on the recovery path and demand likely to return, banks will see more demand for money from the borrowers and the RBI must ensure that there are enough funds.

But aren’t interest rates are already low?

Interest rates aren’t the real decisive factor that is influencing the credit supply in the market. The high-risk aversion of banks, fighting a spike in bad loans and low demand, is limiting credit flow to industries. Loan growth has not picked up despite low lending rates because of poor demand and banks being choosy in picking borrowers.

Where are the interest rates headed?

Interest rates are likely to remain low in the near future unless inflation surprises on the upside. If inflation goes out of control, the RBI will have to hike rates to curtail demand. But going by the last print, the CPI inflation eased to 4.59 percent in December from 6.93 percent in November and is expected to fall further.