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MOSL: ECOSCOPE-Pre-Budget I: Will fiscal policy match monetary policy?

ECOSCOPE: Pre-Budget I: Will fiscal policy match monetary policy?

** With the RBI's three back-to-back 'Operation Twist' transactions (OTTs), wherein it bought longer-dated securities amounting to INR300b and sold short-term treasuries worth INR253b, it is clear that the RBI (a) does not want to add meaningfully to its balance sheet, and (b) is targeting bond yields, wanting the yield curve to flatten.

** The OTTs, thus, are likely intended to offset the adverse impact of INR500-700b additional borrowings to be announced by the central government in 4QFY20 and keep the 10-year yield range-bound at ~6.6%, even after the supply hits the markets.

** However, recent developments - such as rise in crude oil prices, confirmed massive receipt shortfall and higher inflation - have brought back the benchmark 10-year bond yield to ~6.65%, only marginally lower than 6.70% before the first OTT was announced on 19th Dec'19 and as against 6.50% at the beginning of Jan'20.

** If the policy makers still want to target the bond yield and wish to keep it contained at ~6.6%, the fiscal policy has to match the monetary policy. This implies that the government must refrain from issuing additional dated securities to restrict the impact on the benchmark bond yield. Otherwise, the higher fiscal deficit, if any, must be financed through short-dated bills and/or other non-market instruments such as NSSF, etc. With no further supply of dated securities, the 10-year bond yield is likely to remain range-bound and additional issuances of T-bills may flatten the curve more - in line with the monetary policy objective.

** Alternatively, the spending burden could be transferred to various CPSEs to mitigate the adverse economic impact. While issuances of sovereign bonds will remain unchanged, higher public sector borrowing requirement (PSBR) should keep the financial markets generally tight.