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The Reserve Bank of India not only manages the monetary policy in the country, but also performs the role of banker to the Government, raising resources from the market to support the Government's borrowing program. The more well known ways in which the RBI does this, which get widely reported in the media include :
- Setting interest rates at which it will lend to banks, which in turn sets the tone of the rates at which banks will lend to their customers
- Auctioning Government securities and T-Bills to support the Government borrowing program.
What is less known to players outside the financial markets is the other very interesting way in which it attempts to control and influence the money and bond markets - by becoming a market-maker in the market that it oversees and regulates. This market-making function is usually conducted through auctions and open market operations (OMOs).
Auctions
Lets look at the first part of where auctions come in - which is the aspect of funding the Government's borrowing program.
When the Finance Minister announces another year of large fiscal deficits, it means that the Government plans to yet again borrow to fund its ongoing expenditure, since revenues are again falling short of expenses. These borrowings take that shape of the keenly tracked Government Borrowing Program that bond markets eagerly watch out for. A large borrowing program means that demand for money by the Government will be strong and therefore the price of money (interest rates) can go up. Interest rates going up, as we are well aware by now, is bad news for bond markets as bond prices fall to reflect higher market yields.
RBI auctions dated securities (more than 1 year tenor) and T-Bills (less than 1 year tenor) of varying maturities, based on the Government's requirements. If the auction calendar is challenging - which means too many auctions too soon, it has the potential of sucking out liquidity from the system as well as increasing rates - both of which are usually bad news for bond markets. Why does this become bad news? Well, lets understand the demand-supply dynamics of this market a little better.
The buyers of these securities are mainly a set of institutional players - each of whom has a mandate to invest a certain portion of their corpus in Government securities (G-Secs). Banks have to maintain a Statutory Liquidity Ratio (SLR), which is currently 23% of their deposits. As their deposit base grows each year, 23% of that has to be compulsorily parked in G-Secs. Provident funds - which collect money on a monthly basis from salary deductions of millions of salary earners across the country - are also mandated by their investment guidelines to invest large proportions of these funds into G-Secs, which enjoy the highest credit rating, as these are classified as sovereign debt. A large proportion of premiums collected from traditional plans of life insurance companies also finds its way into G-Secs. We also have gilt and income funds who invest in these papers. While players like banks and PFs have a minimum amount that has to be mandatorily invested in G-Secs, there is nothing to stop them from going beyond the minimum. In such a scenario, when the Government steps into the market as an aggressive borrower and offers attractive yields, more money than is mandatorily required flows into buying this high-yielding, high quality paper - which therefore leaves less money available in the system to lend to corporate borrowers and individual borrowers. This sucks out liquidity, drives up rates and makes business conditions less attractive for the private sector. This phenomenon is often described as the Government "crowding out" the private sector.
Open Market Operations (OMOs)
If, in the process of raising money to finance the fiscal deficit, RBI gets apprehensive that the Government might crowd out the private sector, it dons another hat - that of the market maker - to neutralise the negative impact of a large borrowing program.
Liquidity in the market can be tight not only due to the Government borrowing program but also due to seasonal factors - like at the time of advance tax payments, or when farmers draw down loans at the start of the sowing season. When liquidity is tight, RBI comes to the rescue by conducting OMOs.
RBI steps into the market as a buyer of G-Secs. Lenders who are strapped for cash readily sell their surplus G-Sec holdings to RBI and get cash into their balance sheets - which they can now lend into a market that needs this liquidity urgently. When RBI thus infuses liquidity into the market, it brings down short term interest rates, cools down the market and allows normal business operations to continue unhindered. Rigth through 2012, RBI's active policy on OMOs is what has given comfort to the bond markets that despite a large Government borrowing program, markets will not be impacted very negatively. RBI's stance on OMOs is thus almost always welcomed by market participants, as a measure to control the negative impact of a stiff auction calendar.
QE is just another form of OMO
As an aside, the much touted Quantitative Easing (QE) program of the US Fed is in a broad sense, just another form of OMO by their Central Banker. The US Fed has committed to buy back from the market a certain amount of US G-Secs each month, for an indefinite period. As they keep buying these bonds from the market, the market keeps getting additional doses of liquidity - which it must onward lend to borrowers. Surplus liquidity keeps interest rates low. In an ideal world, one would have hoped for borrowers from the real economy to get excited by low interest rates and therefore decide on expanding real business activities spurred by cheap and plentiful finance. This would have got a virtuous circle of growth started off. Unfortunately though, what we are seeing in the developed world is that due to sluggish demand conditions, real economy borrowers are still reluctant to borrow for business expansion. However, investors and speculators are quite happy borrowing at dirt cheap rates and investing in "risk assets" - global equities, commodities, real estate - thus fuelling an asset price bubble rather than spurring real economic growth. But, that's altogether another story.
Auctions are also conducted to drain excess liquidity from the market
Coming back to the story of our own RBI and its OMOs, we've seen how RBI steps in as a buyer of G-Secs and thus infuses cash into a market that needs it desperately. In the same manner, RBI also steps in when the situation is at the other extreme. When there is excess liquidity in the system and money is being freely lent towards funding speculative activities, RBI steps in to drain out or suck out the excess liquidity from the market. It will, in such a situation, announce an auction of G-Secs at a higher interest rate than what is currently prevailing in the market. Institutional players will naturally rush to buy these high coupon papers - which will simultaneously do two things : it will transfer the excess cash from banks to the RBI in exchange for these new GSecs, and it will also drive up yields in the market, as all existing G-Secs will now be re-priced to reflect the new rates that RBI has set. By taking away excess cash and increasing rates in the market, RBI effectively makes it more challenging for speculators - as their access to cheap funds to drive asset prices up, now dries up. This in turn helps bring normalcy to a market that perhaps had begun to look frothy.
RBI thus acts as the referee as well as the star player in this market - by setting the rules of the game and effortlessly stepping into the game when the players are playing the game in a manner that does not meet RBI's objectives of ensuring stability and order in the markets.
Share your thoughts and perspectives
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