RBI move to conduct OMO on state development loans could be a game changer

By facilitating the OMOs, the RBI is assuming a much bigger role than it had earlier been
The Reserve Bank of India’s decision to conduct secondary market purchases of state development loans (SDL), or bonds issued by states, is just the thing needed for investors to take these bonds seriously and start trading on them.

So far, the central bank has been assuring the markets that SDLs are safe, and there is an implicit guarantee on these bonds. The central bank maintains a consolidated sinking fund (CSF) from which market borrowings of states are serviced, and a guarantee redemption fund (GRF), which can be used if there is a default.

Still, foreign investors in particular have been reluctant to buy these bonds. As on October 11, foreign portfolio investors have used just 1.03 per cent of their investment limit of Rs 67,630 crore, shows data from the Clearing Corporation of India (CCIL). In case of government securities, the utilization is 41.13 per cent of the limits.

There are numerous reasons why the foreign investors want to stay away from state bonds. These investors consider state accounting disclosures non-transparent. Many states are now facing huge pressure on their finances due to the pandemic, and on top of it, the centre’s reluctance to pay the Goods and Services Tax (GST) due.

Another big reason why the investors wanted to stay away is that these bonds are illiquid. There is virtually no secondary market for these bonds, and every time states borrow, they do it through new bonds. The sheer number of bonds available in just the 10-year category, make secondary market trading practically impossible. However, the domestic investors still buy these bonds for their portfolio because these can be used to fulfill statutory liquidity ratio (SLR), and also because these bonds also offer 50-60 basis points more than equivalent maturity government bonds at virtually the same risk profile.

But oversupply upsets the markets, and investors reflect their displeasure by asking for more spreads from the states.

This is one issue that the RBI wants to address now.  In its policy, the RBI said it will do open market operations (OMO), through which it buys or sells bond from the secondary markets, in SDLs, “to improve liquidity and facilitate efficient pricing.” Then it goes on stressing that this is done “as a special case during the current financial year.”

The OMOs would be conducted for a basket of SDLs comprising securities issued by states. However, in a cooperative federalism structure, how the bonds will be selected to create the basket will be a big challenge. States that are now dependent on market borrowings to bridge their deficits will obviously want to see their bonds be included for the OMO, whereas, concentrating on such bigger states might upset states that don’t borrow much, for example, from the North Eastern part of India.

Bond dealers say by such OMOs, the central bank would be exposing its balance sheet to sub-national papers, which are not exactly at par with the highest quality sovereign bond, and therefore, doesn’t go well with a central bank’s balance sheet. This is especially when the RBI itself is giving an ‘implicit guarantee’ on these bonds.

Therefore, such SDL OMO would unlikely be the norm, unless the SDL secondary market really becomes deep and the central bank can conveniently sell the bonds at some point in the future.

In the immediate term though, RBI’s OMO measure would be a “big positive for SDL spreads,” wrote ASK Wealth Advisors Research in a report.

The spreads “have been inching up on expectations of increased supply as well as GST compensation news. This brings SDL another step closer to being considered “sovereign” risk, and therefore attract greater foreign investor interest as well, at the margin,” ASK Wealth report said.

The spreads have indeed fluctuated based on the supply of bonds. The spreads should ideally remain at 50 basis points over equivalent maturity GSecs, even as banks are mandated to value these bonds in their books at a spread of just 25 basis points.

However, during the past one month, the spreads have widened quite a bit. On October 6, Assam paid 6.91 per cent interest for their 10 year SDL. On the same day, the 10-year Gsec had closed at 6.03 per cent. The spread, therefore, was close to 90 basis points. At the end of September, the spread was more than 70 basis points at the end of September, which was about 35-40 basis points higher than states had earlier paid.

Fatigue in the bond market is the main reason behind this. Tracking the borrowings by states, Care Ratings noted that in the first half of the current fiscal year, 27 states and two union territories had cumulatively raised Rs 3.53 trillion via market borrowings, which was a 57 per cent increase from the borrowings in the first half of fiscal 2019-20 (Rs 2.25 trillion).

In the December quarter, the states will be borrowing Rs 2.02 trillion, while in the fourth quarter, states are expected to borrow even more.

By facilitating the OMOs, the RBI is assuming a much bigger role than it had earlier been. Some have started comparing the RBI with European Central Bank (ECB).

“OMO in State Bonds is analogous to ECB's bond purchase, multiple nations one central Bank. There should be clear framework in sync with the dynamic objectives, currently this could be linked to shortfall in GST compensations,” said Soumyajit Niyogi, associate director at India Ratings and Research. 

Whether RBI’s OMO helps in creating depth in the SDL secondary markets, though, is anybody’s guess. 
  • RBI OMO on SDLs should bring down the spreads
  • The spreads widened to 90 bps, while banks value the SDLs at GSec plus 25 bps
  • The OMOs however, should be quickly wound down to maintain RBI’s balance sheet strength
  • RBI says the OMO is a special case for this fiscal
  • FPIs have used just 1 per cent of their limits on SDL. RBI could be assuming a role akin to ECB in conducting the SDL OMO

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