Direct finance ruled out as bond buying doubles

The FRBM Act bars RBI from buying bonds directly from the govt in the market

independence of the central bank.

Having so far managed to keep a lid on financing costs for the government, the RBI is unlikely to change its strategy, said Sergi Lanau, deputy chief economist at the Washingtonbased Institute of International Finance.

“The RBI seems very aware of the fiscal financing challenge but is reluctant to engage in direct financing of the deficit,” Lanau said. “This is understandable since history tells us central bank assists to fiscal policy are often abused.”

The RBI has so far cut interest rates by 115 basis points this year and adopted a US Federal Reserve-style Operation Twist— simultaneous purchase and sales of bonds of different maturities—to control borrowing costs. This month, Das announced a package of measures, including ₹20,000 crore of open market bond purchases, meant to reassure traders wordate ried about a debt deluge.

The yield on benchmark 10-year bonds has remained below 6%—a level traders see the RBI trying to defend— despite the government ramping up borrowings this fiscal year to an unprecedented ₹13 lakh crore ($177 billion). That increase in debt could see India’s combined fiscal deficit surge to more than 10% of GDP.

Among reasons for the RBI’s reluctance on debt monetisation may be the economy’s experience in the 1980s when deficit financing led to doubledigit inflation. A repeat will go against the RBI’s primary manof bringing headline inflation to the 4% midpoint of its 2%-6% target range, and keep it from using conventional policy tools to support an economy headed for its worst annual contraction.

The Fiscal Responsibility and Budget Management Act bars the RBI from buying bonds directly from the government in the primary market. Besides, the government’s cautious strategy on fiscal stimulus compared to its peers like Indonesia could pay off.

Analysts at Nomura Holdings Inc. said in a recent note that while a wider fiscal deficit could still give rise to deficit monetisation, they believe it poses less of a risk to Indian bonds than Indonesian debt, given New Delhi’s lower foreign bond ownership—2.3% of outstanding versus 28% in Indonesia.

Investors may also view the RBI’s credibility as less at risk than Bank Indonesia’s, according to Nomura analysts.

THE RELUCTANCE MAY STEM FROM THE POSSIBILITY OF DOUBLE-DIGIT INFLATION AS SEEN IN THE 1980S