The Reserve Bank of India has, over the weekend, hiked the limit for issuance government bonds under the market stabilization scheme (MSS) to INR 1.1 trln. This is up from the previous limit of INR 950 bn. Even the 950 bn limit was an increase from the previous cap of 850 bn and set as recently as Apr 25.
MSS is the mechanism by which the Indian central bank has been sterilizing the (excess) liquidity in the monetary system on an enduring basis. Ironically, the central bank itself is responsible for most of the liquidity generation due to its active intervention in the forex markets. RBI has, under its exchange rate policy, effectively prevented the Indian rupee from appreciating much. This has been done through a process of active intervention in the currency markets through large scale purchases of foreign currency, most of which is an outcome of increased capital foreign capital inflows into the country.
The increase in the MSS limit has been necessisated due to the limited headroom available with RBI on its sterilization efforts. INR 780 bn of MSS issuance is already outstanding. This means that the headroom now available on this account is now INR 370 bn. Since some of the MSS issuance is in the form of treasury bills which mature periodically. These are mostly perpetuated through a refinancing mechanism of issuing fresh bills. Thus, assuming that on an average the central bank issues Rs. 30 bn of longer dated bonds under the MSS mechanism, it has approximately 3 months time till it hits the cap. This is clearly too short a time period for the comfort of the central bank. I’m sure that Mr. Reddy, the governor is wishing for a slowdown in inflows to enable him manage this monetisation better. My feeling is that if it comes to it, he would not hesitate in hiking the cash reserve ratio itself to aid the sterilization efforts.
In the meantime, the Indian currency has appreciated sharply (approximately 10% in 2 months). It has been aided in this move, by a somewhat hands off approach adopted by the RBI. A subtle shift in its exchange rate policy has become noticeable. It no longer seems to be finicky about preventing the rupee from appreciating. Mr. Reddy has also spoken, in some recent media interviews, about the exchange rate policy to be viewed in the larger context of public policy (whatever that statement means).
There is one other reason why the MSS limit would have needed to be hiked. To relieve pressure on the central bank to reduce the statutory liquidity ratio (SLR), the proportion of deposits that a bank has to compulsorily invest in government bonds. This ratio is currently pegged at 25%.
Bank deposits are expected to grow by INR 5 trn this financial year. To meet the 25% norm, banks would have to buy INR 1.25 trn in government bonds. Fresh issuance by the government is budgeted at INR 1.1 trn. Assuming that a significant proportion of the fresh issuance is absorbed by non banks (primarily insurance companies and provident funds), banks would have been left scrambling to meet the SLR requirement, unless it was reduced. By hiking the MSS issuance limit, the central bank has eased the pressure on this front a wee bit.
Clearly, interesting times lie ahead.
