Market stabilisation bonds

ET Bureau Apr 22, 2010, 06.02am IST

Even with a lower fiscal deficit projected for the current financial year, the government's borrowings from the market this year would be Rs 91,000 crore higher than last year, said RBI governor Subbarao in his credit policy statement. But will that be all? What about the bonds that will have to be mobilised to form the central bank's war chest on the exchange rate front? Considering the trend in capital inflows and the need to keep rupee appreciation in check, the RBI would inevitably have to intervene in the foreign exchange market to mop up dollars. When the central bank purchases dollars , it injects fresh liquidity into the system. To prevent such a flood of rupees created as a result of dollar purchases from pushing up the money supply above the desired level, the RBI then absorbs the rupees by selling government bonds.

The bonds used for this purpose are the so-called Market Stabilisation Scheme (MSS) bonds. Right now, their supply with the RBI has dwindled to some Rs 2,700 crore. And these are poised to mature in May. A war chest of fresh MSS bonds would inevitably have to be created, to take on the flood of capital that would inundate India this year. While the MSS bonds are not used to finance the government's expenditure , and do not figure in the fiscal deficit, they do represent a claim on the liquidity in the system by the government . So when these government bonds are issued, as part of the mechanism to stabilise the foreign exchange market, the total government borrowing would go up beyond the level required to fund the fiscal deficit. By how much, of course, is the crucial question. If we expect the central bank to be obliged to add $10 billion to its reserves, in the interest of rupee stability, and it sterilises some 80% of the counterpart rupees created in the process by selling MSS bonds, it would need to have some Rs 36,000 crore worth of MSS bonds in the first place. Of course, the RBI could raise the cash reserve ratio, to mop up the rupee rush created by foreign capital inflows , instead of selling MSS bonds. That's just another way of tightening liquidity. The short point is, liquidity could be tighter than estimated on fiscal counts alone. Unless, of course, further capital controls are deployed.