RBI with huge responsibility – Managing the government’s interest burden or preventing price increases?

The Reserve Bank of India announced a new policy tool to calm the bond markets in its April monetary policy review. In the first quarter of the current fiscal year 2021-22, the RBI has committed to purchasing Rs 1 trillion (one lakh crore) in government securities in the secondary market.

In an effort to stem the rising yields and offset rising borrowing costs, the new tool, known as G-SAP 1.0, was revealed. For the fifth time in a row, the RBI’s Monetary Policy Committee (MPC) kept policy rates unchanged. The reverse repo rate remained at 3.35 percent. The RBI has also decided to keep interest rates low for as long as necessary to support growth. So far, the central bank has used open market purchases to try to lower the interest rate on government bonds. The G-SAP is analogous to announcing a specific schedule for open market purchases of government bonds. It is a variant of the Quantitative Easing (QE) policy implemented by central banks in advanced economies following the global financial crisis.

QE entails central banks purchasing assets on a large scale, such as treasury bills and private sector bonds, in order to directly influence interest rates and risk premiums on private debt. The RBI has committed to purchasing only government securities. In recent years, central banks in emerging economies have used QE to prevent rises in local bond yields and to signal that central banks are willing to purchase government bonds in the midst of large fiscal expansion to respond to a pandemic shock.

This announcement assures bond investors that the RBI will intervene to buy bonds, inject liquidity, and lower yields. Government bond yields have been rising as a result of an increased market borrowing plan, as well as spillovers from a rise in US bond yields. The decision to announce G-SAP elicited a variety of reactions. While the bond market applauded the decision, with the 10-year bond yield falling as much as 7 basis points, the rupee fell 1.52% to 74.56, its lowest level since November 2020.

When the interest rate differential between the US and India is large, foreign capital flows in from, say, the US. An investor may borrow from a country with low interest rates and invest in a country with higher yields. Until recently, the difference in interest rates was driving capital to India and causing the rupee to appreciate. However, due to the RBI’s aggressive bond purchases in recent months, yields have risen at a much slower rate.

Bond yields in the United States, on the other hand, have been rising at a much faster rate since their record lows. As a result, the spread between India’s 10-year bond and the 10-year bond of the United States has narrowed. Following the monetary policy announcement, 10-year bond yields fell to 6.06 percent, resulting in the aforementioned sharp depreciation of the rupee.