In the recent past, RBI has been stating that the Indian Federal fiscal deficit is unsustainable, and can be considered as one of the causes of inflation.
However, its actions are at complete variance to its stance. Lets look at the chart below, showing net RBI OMO purchases as a proportion of net central government borrowing.
Chart 1: RBI purchases as a proportion of net government borrowing
Source: Decimal Point Analytics, Data till May 18, 2012 for latest quarter.
The above chart shows that in the last three quarters, Indian government borrowing has become dependent on the OMO support from RBI. With 79% support in the current quarter, it would not be wrong to say that RBI is the only buyer in town for Indian government debt.
Some analysts might attribute this trend to RBI’s interventions in forex market, being sterilized through government securities markets.
We, on the other hand, are tempted to argue otherwise. In our opinion the primary act is the OMO purchases of government securities by the RBI to fund the fiscal profligacy of the government of India. This results in waning investor confidence and a sharp increase in domestic money supply, both of which coupled with the current account deficit lead to a sharp drop in the value of INR. In our opinion, given the quantum of OMO, RBI intervention in the forex market is only able to partially neutralize the open market purchases being made by the RBI.
Infact, given the above, would it be too much of a stretch to conclude that indirectly the RBI is using the forex reserves to fund the fiscal excesses of the government?
We believe that if RBI is serious about its dual stance of unsustainable fiscal and managing the pace of depreciation of INR, RBI should desist from further OMO purchases.
We understand the need for reasonably expanding base money for a growing economy like India, and as a corollary, the need to reverse a persistent negative liquidity in banking system seen for a last few quarters. Maybe RBI will reason that it is solving these two issues by conducting aggressive OMOs. A better solution to these two issues can come from twin approach of conducting long-term (maybe three to nine months) repos against a wide array of high quality securities combined with aggressive moral suasion of bankers to reverse the liquidity shortfall, by offering appropriate deposit and credit rates mix.