India - RBI as an Oil Spigot?

On May 30, the RBI announced a Special Market Operations (SMO) scheme, motivated as follows (I quote): “Public sector oil companies are among the important participants in the money, foreign exchange, credit and bond markets. Consequently, liquidity and other related issues currently faced by these entities arising from the unprecedented escalation in international crude prices have systemic implications for the smooth functioning of financial markets and for overall financial stability”. At the outset, the transparency with which the scheme has been introduced has to be commended. The issues that merit examination are along two dimensions. First, the logic proffered for introducing the scheme (as enunciated in the RBI circular) is, at the least, debatable; and, second, the wider implications of deploying unconventional schemes for the efficacy and independence of institutions that are tasked to manage aspects of our economy.
The RBI, between June 5 and August 8 in effect provided US$4.4 bn to government-owned oil companies in exchange for oil bonds (outright purchase or collateralised repo). The SMO from the perspective of the RBI is effectively a swap on the assets side of its balance sheet, specifically, rupee-denominated oil bonds for foreign currency reserves. Since the liabilities side of the RBI’s balance sheet is unchanged, the SMO is monetary neutral.
Notwithstanding the language reminiscent of central bank provision of market liquidity for financial intermediaries during times of crisis, the case for the SMO premised on “systemic implications for the smooth functioning of financial markets” is not entirely cut and dry. However, the SMO has everything to do with maintaining petroleum imports into the country. The SMO could have been more accurately christened as “RBI Swap Facility for Oil Companies Routed through Designated Banks”.
The fact of the matter is that the RBI has had to willy-nilly don the mantle of market maker of first (as opposed to last) resort for oil bonds because of scarce interest from banks to buy the bonds or hold them as collateral for the benefit of oil companies. Presumably, this is because the price on offer did not adequately internalise the unattractive caveats of the bonds. The coupon and the non-SLR eligible nature of these bonds (in combination) make them largely unattractive to scheduled commercial banks and other participants in the secondary market. The market would have discounted these bonds on account of the embedded characteristics (contractual savings institutions like insurance companies and pension funds bought some of these bonds only after appropriate haircuts). The magnitude of the discount would have been unacceptable to the issuer (the government) because it would have meant that more bonds would have had to be issued to the oil companies to compensate them for the unpaid subsidy due to them. The SMO has essentially entailed the central bank to buy illiquid bonds issued by the central government to the oil marketing companies in lieu of cash support required to subsidise consumers of energy.
The matter then arises regarding the valuation of oil bonds by the RBI in the absence of a credible market-determined price history for the bonds. It is reported that the oil bonds were priced at a spread of 25 basis points above the yield of G-Sec of the relevant maturity. Of course, this positive spread over G-Sec in itself does not mean that a quasi-fiscal subsidy is not operative. Outright purchases of these securities at prices above fair value (or even acceptance of collateral above fair value) would constitute a quasi-fiscal subsidy from the RBI. Without access to the valuation methodology that would have been deployed, it is difficult to gauge the fair value with accuracy.

It is estimated that oil bond issuance over the current fiscal could be about 2 per cent of GDP; therefore, the money due to the oil companies from the Union government is expected to be huge for the foreseeable future. Unless there is a sharp correction in oil prices or a policy combining adjustment in domestic retail prices and reduction in government duties, the oil companies will continue to require help to source the foreign exchange to import crude oil (although the SMO has been ascribed as a temporary facility). If demand does not adjust, supply will; reports of long lines at diesel pumps in several states show that the oil companies are responding in a manner that is feasible for them. In some parts of the country, demand for diesel for generation sets has increased after the recent price hike because electric supply shortages have intensified. The whole scenario is emblematic of the insidious distortions in virtually the entire energy chain in India.
Several conclusions and observations can be made. First, the dire fiscal situation that the central government finds itself in has now sucked the RBI in its vortex, but it is to be hoped that a durable alternative mechanism will be put in place with alacrity to ensure that the SMO is not further resorted to; it can be argued that some of the hard work over the past decade to ensure that the RBI’s proximate objective for conducting monetary policy is not compromised — by getting stuffed with government paper — has been undone. Secondly, we would be hard-pressed to name another country (even among those that subsidise fuel) that has had to resort to the central bank in this manner. Thirdly, praying for international crude prices to adjust sharply downwards soon does not constitute government policy, sound or otherwise. Fourthly, the proceeds of the oil bonds upon maturity will be in rupees, hence the RBI, if it wants to rebuild official foreign currency assets to make up for the decline on account of the SMO, will have to intervene in the market at the time and buy foreign currency at the ruling market exchange rate (the central bank shoulders an exchange rate risk if rebuilding foreign currency reserves is an objective).