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Will bond purchases aid rupee stability?
The US Fed, the BoE, the BoJ (and possibly the ECB in future) are implementing monetary policy through large-scale bond purchases. In normal times too monetary policy is implemented through bond operations only though, the amounts involved would be smaller.

SINCE 2011 WHEN the rupee slide began, more than one corporate told me that the RBI was taking steps to support the rupee by buying government bonds in the open market! These were not doubts but definite statements that RBI bond purchases would aid the rupee.

Now, one wonders at the low level of awareness in the corporate world about RBI actions, its methodologies and their impact on other financial market variables. At the non-technical level, if we can understand that the rupee’s FX market problems are due to too much of it floating around in relation to the demand for it, we will know that the RBI’s OMO bond purchases would only add more ‘rupee’ fuel to the fire. The rupee would then come under greater downward pressure in the FX market.

And, so it has happened in the past two years and more, as the RBI has relentlessly bought bonds in the open market, pumping more rupees into the financial system which then gets sold down relentlessly in the FX markets.

And, for whatever it is worth, we can predict that such continued RBI OMO bond purchases would only pack greater damage potential for the rupee in the FX markets in the months to come.


Bond purchases is monetary easing only

Incidentally, the focus on OMO bond purchases brings us to another aspect of RBI’s market operations which is grossly misunderstood and which misunderstanding the RBI also seems keen to strengthen.

The point in focus here is the RBI’s conviction that its large bond market purchases are only to relieve liquidity strains in the financial system and should not be construed as monetary policy easing.

For the record, between March 2010 and March 2013, the RBI’s holdings of government bonds rose from Rs.165,000 crore to Rs.700,000 crore – up more than 300 per cent. In the same period, the RBI’s FX assets (in rupee terms) posted only a modest increase to Rs.14,00,000 crore from Rs.11,50,000 crore. Incidentally, the increase in rupee terms of the FX assets on the RBI balance sheet is primarily on account of rupee depreciation; but  in the case of government bonds, there is actual base money creation.  

Now, how in the world can you make this neat distinction that the bond purchases are for ‘liquidity management’ and not actual monetary easing? Incidentally, one thought that altering the conditions – quantum, price, and tenor – of financial market liquidity and through that, interest rates, is the essence of monetary policy operations itself. And that is done only through operations in the money and bond markets.

Indeed, a close analysis of the market would show that investors can, without hesitation, buy GoI bonds at yields around 8.50 per cent - for the RBI is not going to a llow yields to rise above that level. That is, the RBI ‘writes’ a free put option on GoI bonds at 8.50 per cent yields.

Therefore, how does the RBI continue the fiction that bond purchases and monetary easing are two different concepts?

The poignant thing to note here is that this misunderstanding about the true nature of RBI bond purchases and their impact on variables such as inflation, the exchange rate seems to be completely uninfluenced by even the prevailing global environment.

Indeed, anybody following global economics now would know that the US Fed, the BoE, the BoJ (and possibly the ECB in future) are implementing monetary policy through large-scale bond (and other financial assets) purchases only. In normal times too, monetary policy is implemented through bond operations only, though the amounts involved would be vastly smaller.

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