Annual Report

VI.1 Public debt management by the Reserve Bank in 2004-05 was guided by the twin objectives of minimisation of cost over time and lengthening of the maturity profile of debt for both the Centre and the States in a scenario of upward shifting yield curves. The market borrowing programme of the Central and State Governments was successfully completed in easy liquidity conditions. The weighted average cost of market borrowings of the Centre as well as the States increased marginally after eight years of consecutive decline, reflecting the hardening of interest rates attributable to uncertainty surrounding international oil prices, the upturn in global interest rates, buoyant domestic growth and sharp spikes in domestic inflation. The weighted average maturity of the primary issuances of Centre and States under the market borrowing programme during the year declined marginally. The Central Government did not avail of overdraft during 2004-05. The utilisation of WMA by State Governments was also lower as compared with the previous year. Issuances of Floating Rate Bonds (FRBs) continued as part of the endeavour to provide a diversified pool of instruments to investors and in a scenario of firming yields, they facilitated the hedging of interest rate risk. The proposed re-introduction of the Capital Indexed Bonds (CIBs) in 2005-06 would help to widen the investor base and provide the holders with an inflation risk free return on their investment.

VI.2 This section reviews the Reserve Bank’s debt management operations in response to the complexities in market processes, technological requirements for efficient functioning and the ongoing changes in the macroeconomic environment. The review highlights the distinct improvement in the Central Government’s fiscal position, reflected in the build-up of surplus cash balances with the Reserve Bank on an enduring basis despite a sharp decline in gross and net borrowings. The overview of States’ debt management indicates the emergence of financial discipline, reflecting the impact of institutional measures undertaken in the recent past.

VI.3 The Ways and Means Advances (WMA) limits of the Central Government remained unchanged at Rs.10,000 crore for the first half (April-September) of 2004-05 and Rs.6,000 crore for the second half (October-March). The interest rate on WMA continued to be at the Bank Rate and on overdraft at two percentage points above the Bank Rate. A noteworthy development was that the Central Government did not resort to overdraft in 2004-05 for the first time since the operationalisation of WMA Scheme in April 1997 (Table 6.1).

VI.4 The Centre maintained surplus cash balances in its current account with the Reserve Bank during most part of the year, mainly due to substantial inflows on account of prepayment of high cost debt by the States under the debt swap scheme (DSS) and other receipts. Investment of the Central Government’s surplus cash balances in dated securities was discontinued temporarily from April 8, 2004 in order to shore up the existing stock of securities for the conduct of monetary policy. With the introduction of the Market Stabilisation Scheme (MSS) to absorb liquidity, investment of surplus balances was partially restored for investments up to Rs.10,000 crore from June 12, 2004. This limit was increased to Rs.20,000 crore, effective October 14, 2004. As at end-March 2005, the Central Government’s surplus cash balances in the form of investment balance (Rs.20,000 crore) and cash balance (Rs.6,202 crore) amounted to Rs.26,202 crore, almost the same as at end-March 2004 (Rs.26,669 crore) (Chart VI.1). During the fiscal year, the Central Government took recourse to WMA on several occasions till September 9, 2004 but maintained surpluses thereafter.

VI.5 The notified amounts of 91-day and 364-day Treasury Bills (TBs) were increased from Rs.500 crore and Rs.1,000 crore to Rs.2,000 crore each in 2004-05, the increase being entirely on account of issuances under the MSS with a view to absorbing sur plus liquidity from the system. Scheduled issuances of the MSS portion of 91-day and 364-day TBs during the period from November 10, 2004 to December 1, 2004 and that of 364-day TBs auction of December 22, 2004 were cancelled on account of temporary tightness in liquidity conditions. The weighted average yields of 91-day and 364-day TBs increased by 26 basis points and 48 basis points,

respectively, during 2004-05 (Table 6.2 and Appendix Table I.44).

VI.6 Reflecting movements in inflation rates, the primary market yields of both 91-day and 364-day TBs increased by 108 and 135 basis points, respectively, during the year to 5.32 per cent and 5.66 per cent (Chart VI.2).

VI.7 The average implicit yields for both 91-day and 364-day TBs remained stable up to July 2004 but increased sharply to reach intra-year peaks of 5.47 per cent and 5.71 per cent in November 2004. The yields, which were hovering at sub-reverse repo rate levels during April-July 2004, thus rose above the reverse repo rate during August 2004. With easing of headline inflation, the implicit yield declined gradually thereafter. The yield spread between the 91-day and 364-day TBs widened from six basis points in April

2004 to 39 basis points in March 2005. The bid-cover ratio in the auctions was generally more than two during 2004-05, reflecting favourable liquidity conditions and market appetite for shor t term securities (Table 6.3).

VI.8 It was decided in consultation with the Central Government to re-introduce, effective April 6, 2005, fortnightly auctions of 182-day TBs to be conducted on each Wednesday preceding a non-reporting Friday.

The notified amount of 182-day TBs was fixed at Rs.1,500 crore, including Rs.1,000 crore under the MSS. The notified amounts of both 91-day and 364-day TBs were kept unchanged at Rs.2,000 crore, including Rs.1,500 crore and Rs.1,000 crore, respectively, under the MSS.

VI.9 Comfortable liquidity conditions and lower than budgeted market borrowings facilitated a smooth completion of the market borrowing programme of the Central Government. The Central Government raised a gross amount (excluding issuances under the MSS) of Rs.1,06,501 crore (a net amount of Rs.46,050 crore) through the issuance of dated securities and 364-day TBs during the year, significantly lower than Rs.1,47,636 crore (net Rs.88,816 crore) raised during the previous year (excluding Rs.14,434 crore issued under the debt buy back scheme). This was on account of a number of factors. First, the Central Government had privately placed securities amounting to Rs.16,500 crore with the Reserve Bank to prepay relatively high cost external debt during 2003-04; however, no prepayment was effected in 2004-05. Second, the higher amount of market borrowings in 2003-04 resulted in a sharp increase in surplus cash balances to Rs.26,669 crore as at end-March 2004 from Rs.8,905 crore as at end-March 2003; during 2004-05, on the other hand, such cash balances exhibited a marginal decline. Third, investments in 14-day Intermediate TBs emerged as a major source of financing in 2004-05 as compared with 2003-04. Finally, the DSS lowered the Centre’s market borrowing requirement both in 2003-04 and in 2004-05. However, while the impact of the DSS was offset by prepayment of external debt and build-up of surplus cash balances during 2003-04, there was no such offsetting factor in 2004-05, resulting in lower market borrowings.

VI.10 During 2004-05, the Central Government raised a total amount of Rs.80,350 crore through dated securities; of this, Rs.80,000 crore was raised through 19 auctions (comprising 13 reissues and six new issues) and Rs.350 crore by way of private placement (new issue) (Appendix Tables I.41 and I.43). The Centre had raised Rs.1,00,000 crore through 22 auctions (6 new issues and 16 reissues) and Rs.21,500 crore through private placement in 2003-04. Two issuances of Floating Rate Bonds (FRBs) devolved partially on the Reserve Bank and Primary Dealers (PDs) amounting to Rs.847 crore and Rs.985 crore, respectively. This was in contrast to the previous year, when there was no devolvement on the Reserve Bank and PDs. During 2004-05, securities amounting to Rs.350 crore were privately placed with the Reserve Bank as against Rs.21,500 crore (including Rs.16,500 crore on account of prepayment of external debt) in the previous year. The Reserve Bank continued to pursue the policy of elongation of the maturity profile of Government debt while keeping in view investor response. Of the 20 primary issuances under the market borrowing programme during 2004-05, eight securities issued were with residual maturity of more than 20 years. The seven new issues included five issues of FRBs.

VI.11 According to the issuance calendar for the first half (April-September) of 2004-05, dated securities for face value of Rs.59,000 crore were to be issued through auctions. As against this, auctions of dated securities amounting to Rs.54,000 crore were conducted; the auction of Rs.5,000 crore scheduled in April 2004 was cancelled. On September 20, 2004, an indicative calendar for issue of dated securities for the second half (October -March) of 2004-05 for Rs.44,000 crore was issued; of this, Rs.26,000 crore were auctioned, while the balance scheduled auctions for Rs.18,000 crore were cancelled. The weighted average yield of the dated securities issued during 2004-05 worked out to 6.11 per cent as compared with 5.71 per cent during the previous year. The weighted average maturity of the dated securities issued during 2004-05 worked out to 14.13 years as compared with 14.94 years during 2003-04 (Chart VI.3).

VI.12 The weighted average coupon on the outstanding stock of government securities continued to decline during 2004-05. On the other hand, the weighted average maturity of the outstanding securities, which had been rising since 1999-2000, fell marginally to 9.63 years as on March 31, 2005 (Table 6.4).

VI.13 Securities over 10-year maturity constituted the largest share in the outstanding stock of securities as well as in new issuances (Table 6.5). Out of the 121 outstanding marketable securities amounting to

Rs.8,95,348 crore as at end-March 2005, 44 securities with minimum outstanding amount of Rs.10,000 crore or more accounted for 67 per cent of the total outstanding amount as compared with 63 per cent at end-March 2004. 29 securities with outstanding amount between Rs,5,000-Rs.10,000 crore accounted for 22 per cent of the total outstanding amount at end-March 2005.

VI.14 The stock of Central Government securities held by the Reserve Bank fell by Rs.7,071 crore during 2004-05 (Table 6.6).

VI.15 The repayment schedule of outstanding market loans of the Central Government as on March 31, 2005 indicates bunching of repayments between 2009-10 and 2015-16 (Table 6.7).

VI.16 The share of securities with coupon at 10 per cent and above continued to fall in keeping with the declining trend of the last five years (Table 6.8).

VI.17 For 2005-06, the Union Budget has placed net market borrowings (excluding MSS) of the Central Government at Rs.1,10,295 crore (inclusive of net issuances of 182-day TBs). Including repayments of Rs.68,272 crore (Rs.35,631 crore of dated securities, Rs.26,141 crore of 364-day TBs and Rs.6,500 crore of 182-day TBs), the gross market borrowing is estimated at Rs.1,78,467 crore (Rs.1,39,467 crore through dated securities and Rs.26,000 crore through 364-day TBs and 13,000 crore through 182-day TBs). Thus, the budgeted gross borrowings are significantly higher than the actual amount raised in 2004-05. An indicative issuance calendar for issue of dated securities for the first half of the year 2005-06 was issued in consultation with the Government for an aggregate amount of Rs.83,000 crore (Table 6.9). As in the past, the Reser ve Bank will have flexibility to var y issuances of Government securities keeping in view the emerging requirements of the Government. During 2005-06 so far (up to August 19, 2005), gross market borrowing (excluding issuances under the MSS) raised by the Central Government through dated securities, 182-day and 364-day TBs amounted to Rs.89,796 crore (net Rs.54,514 crore) as compared with Rs.55,030 crore (net Rs.18,224 crore) during the corresponding period of the previous year. All issuances were by way of fixed coupon securities as against a share of 59 per cent during the corresponding period of the previous year, reflecting the favourable market appetite for such securities. There has been no devolvement/private placement during the year so far. To facilitate consolidation and impart liquidity to the Government securities market, all the securities were reissuances of securities issued earlier.

VI.18 Instrument diversification has been a key component of the Reserve Bank’s initiatives for the development of the Government securities market. As a part of this effort, a capital indexed bond (CIB) was issued for the first time on December 29, 1997. Subsequently, there was no further issuance of CIB mainly due to lack of response of market participants for the instrument. Taking into account the past exper ience as well as internationally popular structure of CIBs, a modified structure of CIB is proposed to be re-introduced (Box VI.1).

Capital Indexed Bonds (CIBs) minimise the inflation risk to the investors and issuers by adjusting both the principal and coupon payments to the changes in inflation. The CIBs are a preferred investment vehicle for investors sensitive to inflation risk. From the issuer’s perspective, the CIB helps in reducing cost of borrowing as it eliminates the ‘inflation risk’ premium.

Co-existence of CIBs and nominal bonds provides useful information on ‘inflationary expectations’ or ‘break even inflation rate’ to both the policy makers and the market participants. The ‘break-even inflation rate’ is defined as the rate of return that equates the real yield of a CIB with the rate of return of a nominal bond of the same tenor if both are held till maturity.

The two most important issues relating to the design of a CIB are: (i) the selection of an inflation index and (ii) the indexation process in the design to deal with indexation lag. Ideally, the CIBs should be linked to an inflation index which is a perfect measure of inflation for all sections of society and is available at high frequency without any lag. In reality, there are several measures of inflation applicable to particular sections of society, but none of them meet the ideal conditions. Indexation lag arises from (a) publication lag and (b) institutional lag. The publication lag arises on account of some delay with which the inflation data are published; the institutional lag, on the other hand, may arise due to arrangements for trading and settlement of bonds between coupon payment dates. For a bond offering semi-annual coupon payments, the indexation lag on account of institutional factor would be six months. As the length of indexation lag has direct relationship with real value certainty or level of inflation protection, it is always desirable to minimise indexation lag.

Internationally, there are two broad designs of indexed bonds - the UK model and the Canadian model. While the UK model takes aggregated length of indexation lag as it is, the Canadian model brings down the length of indexation lag by eliminating institutional lag. Under the Canadian design, the inflation indexed principal can be derived on a daily basis by linear interpolation between the inflation index number applicable for the first day of the month in which the settlement falls and the inflation index number applicable to the first day of month immediately following the settlement date. The uplifted principal over the base thus arrived is used to calculate accrued interest on the CIBs for any particular date with indexation lag limited to the publication lag. Considering the inherent superiority of the Canadian model, many Treasuries the world over have used it to design their inflation indexed securities. Prominent among them are the United States, France, Sweden, South Africa, and New Zealand.

1. Sack, B. and Robert Elsasser (2004), ';Treasury Inflation-Indexed Debt: A Review of the U.S Experience';, Federal Reserve Bank of New York Economic Policy Review, May: 47-63.

2. Wilcox, David W. (1998), ‘Policy Watch: The Introduction of Indexed Government Debt in the United States’, Journal of Economic Perspectives 12,No.1 (Winter): 219-27.

VI.19 The Internal Technical Group on Central Government Securities Market had recommended, inter alia, introduction of ‘When Issued Market’ and limited short selling in Government securities. These recommendations would be considered in consultation with the Central Government (Box VI.2).

';When, as and if issued'; [also known as ';when-issued'; (WI)] markets in Gover nment securities function somewhat like trading in a futures market in that positions may be taken and covered many times before the actual settlement date. Such trading takes place between the time a new issue is announced and the time it is actually issued. WI trading has certain advantages like facilitating the distribution process for Government securities by stretching the actual distribution period for each issue and allowing the market more time to absorb large issues without disruption. It helps price discovery by reducing uncertainties surrounding auctions by enabling bidders to gauge market demand and price the securities being offered.

International experience suggests that the estimated aggregate size of outstanding positions in the WI market typically exceeds the quantity of securities to be sold at that auction. Those positions can be taken more cheaply and potentially in greater size (due to the lack of a delivery requirement) during the WI trading than in subsequent trading. Participants normally reduce the size of outstanding positions in the WI market as the issue date approaches. There is, however, the risk of participants overestimating their ability to cover short positions prior to settlement.

VI.20 During 2004-05, the average utilisation of special WMA, normal WMA and overdrafts by the State Governments was lower than the previous year (Chart VI.4). The improvement in the overall cash position of the States was also reflected in the spurt in investments in 14-day Intermediate Treasury Bills (Table 6.10).

VI.21 State Gover nments, excepting Kerala, Arunachal Pradesh, Mizoram, Nagaland, Tripura and Uttaranchal resorted to WMA for a fewer number of days as compared with 2003-04 (Table 6.11). The recourse to overdrafts by the State Governments also showed improvement over the previous year. As many as 13 States did not avail overdrafts in 2004-05.

VI.22 Effective April 1, 2005 the aggregate normal WMA of the State Governments, which is based on the recommendations of the Ramachandran Committee, was revised upwards by 9.8 per cent. The increase is due to the higher average revenue receipts of the States in the preceding three years. The WMA limit for non-special category States was revised upwards by 9.4 per cent for the year 2005-06. In the case of special category States, there was an increase of 13.5 per cent (Table 6.12). The Advisory Committee on Ways and Means Advances to the State Governments (Ramachandran Committee; January 2003) had recommended that the formula and the limits of WMA to State Governments may be reviewed in totality after receipt of the recommendations of the Twelfth Finance Commission (TFC). Accordingly, an Advisor y Committee on Ways and Means Advances to the State Governments was constituted in May 2005.

VI.23 The net market borrowings allocated to the States for 2004-05 amounted to Rs.36,935 crore, including additional allocation of Rs.18,805 crore under the DSS. Taking into account repayments of Rs.5,123 crore, the gross allocation amounted to Rs.42,058 crore in 2004-05. As against this, gross market borrowings during 2004-05 by the State Governments were lower at Rs.39,101 crore. An amount of Rs.16,943 crore was raised under the DSS during 2004-05. The gross borrowing also included an additional amount of Rs.1,387 crore for prepayment of loans from the NABARD under the RIDF Scheme (Table 6.13).

VI.24 Of the total borrowings by States during 2004-05, 98 per cent was through sale of securities on a tap basis (Table 6.14).

VI.25 Borrowings raised by way of auctions aggregated Rs.885 crore accounting for two per cent of total borrowings (Table 6.15).

VI.26 The weighted average yield of State Government securities increased during 2004-05 while the weighted average maturity declined to 10.01 years in 2004-05 from 11.01 years in 2003-04. While the cut-off yield in the auctions ranged between 7.10-7.25 per cent, the coupon of the tap issuances ranged between 5.60 and 7.36 per cent

(Table 6.16). The investor response to market borrowings by some States was rather lukewarm in 2004-05, reflecting both demand and supply side factors. The response to tap issues held in the year 2004-05 was not encouraging (the tap issues closed with shortfalls except on two occasions), though there was surfeit of liquidity in the system. The spread in the cut-off yields in the auctions also widened. In this context, the need for improving the secondary market liquidity in State Government securities has received increasing attention.

VI.27 At end-March 2005, 60 per cent of the total outstanding debt of State Governments was in the maturity bucket of 6-10 years as compared with 54 per cent as at end-March 2004 (Table 6.17).

VI.28 The maturity profile of outstanding State Government Securities and Power Bonds issued by