One of the earliest challenges Yaga Venugopal Reddy faced after taking over as Governor of the Reserve Bank of India (RBI) in 2003 was to deal with the excess liquidity brought into the system by overseas capital flows to the stock markets, and for investment in factories or plants. The flows had started building up several months before he took over, prompting the government and RBI to implement measures to neutralise their impact.
In situations of heavy foreign exchange flows, the central bank typically undertakes a sterilisation operation, which begins with the release of rupees to buy the foreign assets — the dollar, the pound or any other currency. The higher money supply, however, carries the risk of inflation, and impacts interest rates — that is why the RBI then sells government bonds or securities from its portfolio to reduce liquidity.
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The RBI had been using its Liquidity Adjustment Facility (LAF) — an instrument of stabilisation through the buying or selling of government bonds or securities — for months to neutralise the impact of foreign exchange inflows. But the flows continued unabated, taking India’s foreign exchange reserves to $ 95 billion by November 2003 from a little over $42 billion in March 2001. Reddy, who had come back from the International Monetary Fund that September to take over at the RBI from Bimal Jalan, was anticipating more capital inflows, given that global markets too were awash with liquidity. But the stock of bonds or securities the central bank would need to counter the impact of these flows was limited. The other difficulty lay in assessing how much of these inflows would endure, and how much would flow out in the near term.
Even before Reddy took over as Governor at the RBI, the government and RBI had started to pre-pay part of the country’s bilateral and multilateral external debt, leading to an outflow of foreign exchange. This wasn’t taken too kindly by donor countries such as Japan and some European countries. In FY ’03 and FY ’04, India pre-paid $ 6.9 billion of its external debt. But that wasn’t going to be enough in the circumstances it faced.
An RBI internal working group then came up with some solutions such as treasury bills or bonds or securities, in line with what some countries like Korea, China and Malaysia had done. But the law governing the RBI did not provide for the bank to issue securities of its own. Imposing a Cash Reserve Ratio or CRR — which is to force banks to mandatorily park a part of their cash with the RBI — was an option too, but it wasn’t considered as it would have impacted the banks’ balance sheets and the financial system.
That’s when the option of a new category of bonds or securities as part of a Market Stabilisation Scheme or MSS was discussed. The government would issue a new category of bonds specifically to offset the impact of excess liquidity. Unlike in the case of normal borrowings by the government which goes into the Consolidated Fund of India — from where money is disbursed to pay salaries or interest, and to build assets — the market stabilisation bonds were proposed to be used to absorb excess capital flows. This implied that the funds could not be used by the government for its own expenditure, and would be maintained in the public account.
For the government, the issue at stake was the cost of this exercise. Issuance of bonds or securities by the government would mean adding to its debt, and the fiscal deficit. After initial resistance, it was agreed that the interest payments on such bonds would only be taken into account for the fiscal deficit. Governor Reddy then met Finance Minister Jaswant Singh and convinced him of the merits of the proposal. One of them was that, if the cost of the sterilisation was borne by the RBI, it would mean a lower transfer of surplus to the government. Rather, the government would be better off underwriting the cost, it was pointed out.
And that is how Market Stabilisation Bonds — one of the first bonds of their kind in the world — were introduced in April 2004 after the RBI and the government signed a formal Memorandum of Agreement to make a distinction between normal liquidity and extraordinary liquidity. A cap of Rs 35,000 crore was put in place for FY 05, and the first of these bonds were then launched with maturities in excess of five years. P Chidambaram, who took over as Finance Minister in the UPA government in July 2004, wanted to know from his officials how this scheme was defined, and its fiscal implications. By 2009, as the UPA government announced an economic stimulus after the global financial crisis during Pranab Mukherjee’s tenure as Finance Minister, the government decided to review the agreement, and signed a fresh one to convert these bonds into normal borrowings.
The government and the RBI are now in talks to issue such bonds again. But this time, the liquidity surplus is completely different — brought closer home after a fiat by the government scrapping high value notes led to deposits in banks swelling. That excess liquidity is being sought to be absorbed through these bonds — over a decade after it was first designed in the country. The other difference, of course, is that ironically enough, the public has no cash in hand this time. Also, unlike the last time, banks will be hit as the RBI has raised the CRR on incremental deposits between September 16 and November 11, 2016, to absorb the liquidity. It has termed it as a temporary measure — to be reviewed on or before December 9.