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Budget 2021’s spending push and pro-growth announcements have enormously uplifted the environment. But the activist fiscal policy has driven the RBI to fight fires too many. The massive increase in market borrowings spooked bond markets notwithstanding the comfort measures provided by the monetary policy review days later.
An additional Rs 800 billion to be borrowed until March will aggregate to Rs 12.7 trillion this year, and to finance the scaled-up expenditures in FY22, the government will borrow Rs 9.7 trillion, the decade’s highest at 4.3 percent of GDP. Ever since, the RBI, which was already engaged in heavy forex intervention in spot and forward markets, has been battling in the bond market as well.
The pattern is of devolving bond auctions, followed by the central bank’s announcement of open market operations (OMOs) and other special auctions, raising underwriting commissions to primary dealers to all-time highs, possible moral suasion for acceptance at desired rate, secondary market buys in one fell swoop, and so on. The RBI is determined to keep the benchmark 10-year bond yield at 6 percent or below, as even government officials underlined in post-budget remarks.
In an unusually aggressive response, it bought nearly three-fourths of announced securities in the 10-year segment alone as a strong signal — forcing its resolve down the bond market. This, after the monetary policy review helpfully extended the held-to-maturity relaxations for banks until March 2023.
Successive OMOs thereafter have kept the central government’s borrowing costs low. But the heat is spilling over to state government bonds; yields on these have leapt, crossing 7 percent recently.
The RBI is not just trying to attain the interest rate objective but also that of the exchange rate. It has been busily intervening for long, along with managing yields even before COVID-19 arrived. But the constant, heavy influx of foreign capital in recent months and related intervention now face a changing configuration: the slow retreat or retrenchment of excessive liquidity that started with announcement of a two-step reversal of last year’s lowered cash reserve requirements at the February 5 review. Excessive intervention in the spot market conflicts with this objective. The central bank has been compelled to intervene more in the futures and forward segments, driving up the forward premia across tenures.
Balancing twin objectives, interest rate and exchange rate, is a constant challenge for monetary management. It is also unsustainable for long periods and vulnerable to triggers and risks. Determined to keep borrowing costs lower for government, the RBI has dramatically expanded its arsenal to anchor the bond yield. But how successfully, and for how long, it can do so is the question. Absent any adverse developments and shocks, it can manage to straddle the two goals by shifting between instruments and occasional pauses to ease pressures for a while.
Recent developments suggest the RBI might be responding to the shooting global oil prices by letting its hands off the rupee for a while perhaps: the exchange rate has been strengthening a while — the rupee is up 1 percent from its average December 2020 value and 0.4 percent from that in January. Forex currency assets have declined in the first fortnight this month — $4.9 billion in the week ended February 5 and $1.38 billion the next. It will be known only with a lag if this is a temporary reconciliation of two objectives through exchange rate response to counter threats of raised inflation risk and expectations.
Over a longer period however, the challenges are likely to intensify. For one, markets have absorbed that the need for large sovereign borrowings is long-lasting because the alternate financing plans announced, viz. privatisation and monetisation of assets, are too uncertain with disappointing past outcomes.
Two, inflation risk remains; if the dynamics deteriorates, forcing the RBI to shrink liquidity at a faster pace, it will not be able to repress yields so much.
Three, global developments could evolve into tightening constraints, e.g. the return of US inflation could compel the US Federal Reserve to reappraise its extraordinary monetary commitments sooner than expected; the $1.9 trillion Joe Biden stimulus has already sparked concerns about inflation, which is being hotly debated. It would be difficult to keep local currency bond yields too divergent from global ones if this materialises; a preview is manifest in the devolution of yet another bond auction last week as investors demanded higher premium to retain parity with US yields.
Finally, potential triggers cannot be ruled out; for example, the possibility of a Taper 2.0, a repeat of the 2013 market fears generated by the Federal Reserve Chairman’s expression of intent to scale-back its monetary stimulus.
For now, the market manipulations and interventions are much helped by the global views, including the IMF’s, on the roles and responsibilities of central banks and governments to cooperate in the fight against a pandemic. But it is unknown how long these endorsements will protect emerging market economies and if the familiar, long-standing market rules could come into play sooner than later.