The Reserve Bank of India’s plan to conduct open market operations in state bonds for the first time ever got an ovation from the bond markets, with yields falling in the first auction after the announcement.
On Tuesday, the weekly state bond auction saw 13 states raise Rs 19,250 crore. The weighted average cost of borrowings fell to 6.50% – 30 basis points below last year, according to data from CARE Ratings The spread charged for 10-year state bonds over central government bonds narrowed to 68 basis points – 20 basis points below a week ago.
The drop in borrowing costs was driven by the promise that the RBI will buy state State Development Loans or bonds in the open markets for the first time, providing an additional source of demand for these securities at a time when their supply is set to rise.
While the demand-supply dynamics are relatively easy to understand, the RBI will need to tread tricky ground to set up this newly-introduced facility. Not least because it comes as a time when centre-state relations are frayed due to the debate over GST compensation.
Let’s start with the easier question.
Does It Add Risk To The Central Bank Balance Sheet?
When the RBI buys central government bonds as part of its open market operations, it holds these bonds on its balance sheet with a zero risk-weight assigned to them. Will buying state bonds add an additional element of risk to the central bank’s balance sheet? The answer is no. Under Basel norms, the risk weight assigned to claims issued by state governments is zero. As such, the purchase of state bonds will not add a new element of risk to the central bank’s balance sheet.
How Much State Debt Will The RBI Buy?
This is where it starts getting complex.
The RBI’s decision on how much in central government bonds it decides to buy via open market operations is usually driven by its assessment of the durable liquidity needs of the economy. While the market often perceives that the central bank’s OMO bond purchases are driven by attempts to cool down yields, the central bank will maintain that it is the liquidity needs of the economy that drive these purchases. Ensuring that the government’s borrowing costs remain low is a byproduct of the decision.
If that is the case, what will determine the amount of state bonds that the central bank will buy?
One option is that the RBI determines the total amount of liquidity it wants to add via open market operations and then infuses a part of it via a purchase of state bonds rather than central government bonds. In this scenario, it will be a zero-sum game because while creating room for states to borrow more, the RBI will reduce the space to support central government borrowings. If that results in an increase in central government yields, state borrowing costs, which are benchmarked to central bonds, will rise in any case.
So it would make sense for the RBI to buy state government bonds over and above the liquidity it intends to infuse via central bond purchases.
But if liquidity is not the objective to purchase state bonds, then is it yields? If so, will the RBI use an average historical spread to decide when it intends to jump in with an open market operation? If that’s the approach it takes, it will jump deeper into yield management.
In its statement on Friday, the RBI did admit that pricing is a driving objective and was quick to add that this is a one-off measure.