Switching Operations used by RBI

 

Switching Operations

 

Recently the GOI bought back 6.18% bonds maturing in 2024 worth 226.10 billion rupees ($2.78 billion) at a price of 98.62 rupees while it issued 8.28% 2032 bonds worth 210.26 billion rupees to the RBI at 106.05 rupees, as per the RBI. Such operations are called switch operations which are undertaken with the sole purpose of smoothening the liability profile of the issuer. The 10-year government security’s yield fell by 7 basis points after government switched bonds and securities worth rupees 1.19 trillion with the RBI which brings down the redemption pressure on Indian government by around rupees 62,000 crore. 
 

What are bond switch operations?

Bond switching operations allow governments to repurchase the older sovereign bonds (basically short-term) and in their place issue newer bonds (long-term) to the participants. Since such operations are cash neutral as fresh securities are issued which replace the old existing securities. The bond which is exchanged is called the sourced bond and the newly issued bond is called the destinated bonds.

 

Such operations help governments in maintaining their fiscal deficit targets by postponing the redemption pressure for the earlier issued sovereign bonds, further reducing the cash outflow. 

These transactions are mainly conducted in the market for benchmark bonds which are debt instruments issued by central government backed by sovereign guarantee and representing a standard against which performance of other bonds in the economy can be measured. So, it also helps in ensuring the stability and enough liquidity within the bond markets.

GOI fiscal deficit stood at rupees 17.33 trillion for 2022-23 against the budgeted amount of rupees 16.61 trillion, to close these funding gaps the sovereign relies on borrowings. The net issuance of funds through dated securities for the previous quarter (Q4 of FY23) stood at rupees 2.72,468.33 crore as compared to rupees 84,750.7 crore during Q4 of FY 22. Dated securities consist of mainly T-91 bills, 10-yr and 5-yr government bonds known as benchmark bonds and some state provident funds. The following graph shows the amount of outstanding dated securities of Indian government.

 Since the outstanding borrowings can increase or decrease abruptly operations such as switching helps the Indian government to smoothen their liability payment schedule.

Since interest to be paid on these securities determine a major portion of the government expenditure, switching expensive (off the run bonds) with cheap (on the run bonds) helps in cutting revenue expenditure of the Indian government. But such buyback operations tend to have some costs associated with them which mainly include the following:

·         Price Effect: When a financial intermediary/firm have limited risk bearing capacity and investors face imperfect capital mobility a large buyback operation may tend to raise the price of bonds that are eligible for repurchase by the government.

·         Bid-Sharing: Bidders placing bids that are below the true value of a good so as to avoid the winner’s curse during auctions. Since switch operations are conducted on a large scale there is always a possibility of the government overpaying for the repurchase of dated securities to attract investors.

These operations tend to reduce the short-term interest rates as the government buys short-term securities in bulk and replaces them with longer maturity securities which tends to increase long-term interest rates in the markets causing the steepening of the yield curve which is beneficial of the profitability of financial institutions like banks.

 

 The above graph shows the difference between yields of older bonds issued earlier and coupons of outstanding bonds.

Since bond switching is not the only operation that RBI undertakes to maintain liquidity in the economy. Its interaction with these other tools needs to be analysed properly since an increase in repo rates by RBI to rein in the soaring inflation makes the yields very volatile especially of the long-term maturity hence reducing their demand in the market which further hinders the operation of bond conversion as there will be less investors to buy long duration bonds from the government.

 The above shows the volatility in the prices of the total central government securities issued by the Indian government.

Due to the increased volatility in India market because of high inflation levels and various geo-political events there is consistent selling of India securities by foreign investors which include Government securities too, around May 2022 foreign portfolio investors sold $697 million G-sec and a total of $1.19 billion worth of government securities were sold during the entire financial year of 2022. So, by conducting switch operations the government tries to maintain the liquidity of the sovereign bonds during times of high volatility, as investors selling these bonds are fully aware that the Indian government will help in redeeming the older bonds by issuing new bonds in the market.

 

But switch operations tend to be different from operation twist.

Operation twist is a type of quantitative easing used by RBI to manage the yields curve in the bond market. It includes simultaneous purchase and sale of government bonds.

By purchasing long-term bonds RBI tends to increase their prices and reduce their yields.

By selling short-term bonds at the same time RBI tends to reduce their prices and increase their yields.

So, such operations are done with the motive of reducing long-term interest rates which tends to boost the economy by making loans less expensive for financing various projects. Since short-term rates tend to attract arbitrageurs i.e., foreign portfolio investors who flee the markets immediately at the first sign of danger, keeping short-term rates high are also an important element of maintaining liquidity in the market.

Difference:

But switch operations are just a mechanism to postpone the liability schedule of the government rather than managing the yield curve. Also at the present moment when the interest rates are already high around 6.5% which further raises other interest rates in the economy this is done to counter high inflation rates, the RBI can’t just increase the short term rates further by using operation twists as this would compromise the growth of the Indian economy by making the loans exorbitantly high to finance consumption.

 

When the two operations are conducted at the same time the net effect results in short-term securities being replaced by long-term securities on the RBI’s books and pushing the debt payment obligations further away which tends to increase the term premium in the bonds market. For example, back in 2020 when the government replaced bonds maturing in 2020 with the 10-year benchmark 6.45%, 2029 bond under its switch operations, while the RBI bought the 2029 paper and sold those maturing in 2020, this resulted in replacing 326 billion rupees worth of short-term bonds with long-tenure securities on the RBI’s book which increase the total quantum of gilt switches to 727.17 billion rupees well beyond the Union budget’s target. Only because whenever the sovereign yield curve becomes too steep for the central bank's comfort, the logical thing for it to do is to discontinue switch auctions from being held in the market and participate in gilt switches with the government.  But we know that switching operations by the government maintains the liquidity of the sovereign bonds so reducing such operations makes investing in long duration sovereign bonds less appealing which further increases their yields.

 As the above graph shows that the term premium indeed widened when government suddenly stopped using switch operations along with operation twists.

And we know that rising long term yields is supposed to increase the term premia which is not supportive for maintaining an economy during times of high volatility which dents the confidence among business and consumer groups thus lowering consumption and investment expenditure. Hence, we can conclude that the operations of switches in the bond market by the Indian government is important to ensure smooth operations of the Indian bond markets.