The Indian government has created provisions to issue special bonds up to £60 billion, to absorb the temporary surplus with banks created by deposits of demonetised currency which crossed £80 billion last weekend. The RBI will sell the bonds called Market Stabilisation Scheme, to banks on behalf of the government. Although the MSS is an existing programme, the current limit was only £3 billion which has been raised to £60 billion. Money raised by the sale of these bonds does not add to the fiscal deficit and cannot be used by the government.
The first tranche of the MSS bonds drew £2 billion at a cut-off yield of 6.16 per cent. Armed with the new instrument to soak funds, RBI might relax the rules on cash reserve requirement under which it has impounded £32 billion of bank deposits. Even though the government has recorded a massive amount as deposits post-demonetisation, the money can't be used in the long-term as most of these are expected to be withdrawn.
The surge in bank deposits has forced banks to invest in liquid money market instruments causing volatility. To maintain order it was imperative for the RBI to lock up some of the funds. The cost of impounding these funds were first borne by the RBI which borrowed under the reverse repo facility in exchange for bonds. On November 25, the amount parked with the RBI under reverse repo, crossed £52 billion. Since the bank was on the verge of running out of government bonds, it passed the cost to banks by asking them to lock funds up to £325 billion in the form of cash reserves with the central bank which would not earn any interest.
The sudden change of rules created a situation where banks were incurring a loss of about £5 million every day for the extra cash they were receiving due to demonetisation. Now to compensate banks for the losses, the government and the RBI are issuing these bonds. Soumya Kanti Ghosh, group chief economic advisor, economic research department, SBI, said, "MSS will suffice to drain the excess liquidity from the system if managed properly. We maintain that the temporary incremental CRR hike may now be withdrawn. Otherwise, the two together may work as a double whammy in terms of pushing up government securities yield and impending bank lending transmission."
Last week, RBI governor Urjit Patel said the unprecedented increase in CRR was a temporary measure until the government increased the limit to issue MSS bonds. Since MSS was meant to absorb liquidity, bonds witnessed selling with the benchmark yield on 10-year gilts rising to 6.27 per cent from its last week's close at 6.21 per cent.
