In A First, RBI To Buy State Government Bonds Via Open Market Operations

RBI to conduct open market operations in state bonds as a special case this financial year.

 Indian two thousand and five hundred rupee banknotes are arranged for a photograph in Mumbai, India (Photographer Dhiraj Singh/Bloomberg)
Indian two thousand and five hundred rupee banknotes are arranged for a photograph in Mumbai, India (Photographer Dhiraj Singh/Bloomberg)

In a first-of-its-kind measure, the Reserve Bank of India will buy bonds issued by state governments via secondary market open market operations, to ensure they don’t face rising interest costs amid high borrowings.

Announcing the monetary policy review and measures to soothe financial market, RBI Governor Shaktikanta Das said the central bank would conduct open market operations in state development loans.

The RBI would conduct these OMOs as a special case during the current financial year in order to address concerns about illiquidity and absorptive capacity for the total government borrowing in the current year, Das said.

This is important from the point of view of smooth and seamless transmission of monetary policy impulses as well as the completion of market borrowing programmes of the centre and states in a non-disruptive manner with a normal evolution of the yield curve.
Shaktikanta Das, Governor, Reserve Bank of India

While OMOs in central government securities are routine, this is the first time the RBI has announced OMOs for state government bonds. It comes at a time when the RBI is eager to ensure that financial conditions don’t tighten and derail early signs of a recovery in the Covid-hit economy.

“ market stability and the orderly evolution of the yield curve are both public goods at a time when the pandemic has induced higher borrowings for both the central and state governments,” Das said.

Along with the accommodative forward guidance on monetary policy well into next year, the RBI said it would increase the size of each open market operations for central government bonds to to Rs 20,000 crore from Rs 10,000 crore. The central bank also introduced an on-tap long term repo operation, which will provide Rs 1 lakh crore in liquidity to banks for a three-year tenure.

For the bond market, this is like Christmas came early, said Arvind Chari, head of fixed Income, Quantum Advisors. “Everything that the bond market has asked for, the Governor has delivered. It is a very, very significant policy for bond markets.”

Bond yields should head down after this, Chari said.

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Supporting Higher State Borrowings

Since this is the first time the RBI is buying state government bonds, the modalities would need to be worked out.

Saugata Bhattacharya, chief economist at Axis Bank said that no statutory changes will be needed to permit the central bank from buying state bonds. Yet, the central bank would need to work out the manner in which it decides the quantum of purchases from each state and the extent of purchases.

State governments have borrowed nearly Rs 3.76 lakh crore through SDLs between April and the first week of October, 53.6% higher than during the same period in the previous year, according to ICRA Ratings. According to the borrowing calendar published by the RBI, they are expected to borrow an additional Rs 2 lakh crore during the October to December quarter.

In recent auctions, the increased borrowings have led to higher spreads for state government bonds. The spread is the additional amount sought by investors over the benchmark central government bond yields.

According to a Care Ratings report, the weighted average yield on SDLs (across states and tenures) stood at 6.8% as of October 6, around 23 basis points higher than the previous week and 31 bps higher compared to a month ago.

“The RBI’s announcement of OMOs in SDLs should reduce the spread of yields over government securities,” Chari said.

According to Abhishek Upadhyay, senior economist at ICICI Securities, SDLs are a risk-free asset, so there is no legislation hurdle that binds the RBI from buying or selling these securities.

“There could be logistical issues, however, unlike in case of government securities, since the RBI will have to decide which states to buy and in what proportion, whether they should intervene across the curve and how much variance to allow in terms of cutoffs prices,” he said. “Investor feedback could prove useful here in deciding the OMO purchase details, to gauge which stocks banks may be willing to tender, and crucially at the right prices, given that the RBI recently had to reject all offers in a G-Sec OMO auction because it would have otherwise sent a wrong yield signal.”

The RBI’s support to state bonds also comes against the backdrop of an ongoing tussle over GST compensation between states and the centre. Should states agree to borrow to meet the gap in GST compensation, the supply of state bonds will rise further.

This step allows states to be far more comfortable in the second half in terms of borrowing, said Suvodeep Rakshit, economist at Kotak Institutional Equities.

The RBI would be cognizant of the fact that there could be larger market borrowing from the states. Also, you can do SDL OMOs for the states that would be borrowing more and not all states. What you need guidance on is how much they are going to buy and from whom you are going to buy.
Suvodeep Rakshit, Kotak Institutional Equities