What is Market Stabilization Scheme?

To understand this we need to take a look at the year 2004 when FIIs (Foreign Institutional Investors) started bringing in dollars to buy Indian stocks. This has resulted in an oversupply of US dollars in the Indian market. RBI bought dollars, thus creating an equivalent amount of rupees. This dollar buying raised forex reserves from $100 bn in January 2004 to about $300 bn by 2007-08. Thus there was a liquidity overhang that was caused by the inflow of dollars. This has forced the government to mop up the rupees by creating the MSS bonds.

MSS was introduced by way of an agreement between the government and the Reserve Bank of India (RBI) in early 2004. Under the scheme, RBI issues bonds on behalf of the government and the money raised under bonds is impounded in a separate account with RBI. The money does not go into the government account. As on October 22, 2008 the balance under MSS stood at Rs 1,71,317 crore.

The Government of India and the Reserve Bank of India have today formally signed a Memorandum of Understanding (MoU) detailing the rationale and operational modalities of the Market Stabilisation Scheme (MSS). The scheme would be effective from April 2004. An advance schedule for the borrowings under the MSS for the first quarter of 2004-05 is being announced separately. The main features of the MoU are: 1. The Government would issue Treasury Bills and/or dated securities under the MSS in addition to the normal borrowing requirements, for absorbing liquidity from the system. 2. The Treasury Bills/dated securities issued under the MSS would have all the attributes of existing Treasury Bills and dated securities; specifically, these would be issued and serviced like any other marketable government securities and will thus be eligible securities for Statutory Liquidity Ratio (SLR), repo and Liquidity Adjustment Facility (LAF). 3. The Treasury Bills and dated securities will be issued by way of auctions to be conducted by the Reserve Bank. 4. The Government, in consultation with the Reserve Bank, will fix an annual aggregate ceiling for Treasury Bills and / or dated securities under the MSS. This ceiling will

hold good till further revision during the course of the year. For 2004-05, the ceiling shall be Rs.60,000 crore. 5. The actual outstandings under the MSS would not exceed the ceiling or the revised ceiling at any point of time. 6. The amounts raised under the MSS would be held in a separate identifiable cash account titled the Market Stabilisation Scheme Account (MSS Account) to be maintained and operated by the Reserve Bank. 7. The amounts credited into the MSS Account would be appropriated only for the purpose of redemption and / or buy back of the Treasury Bills and / or dated securities issued under the MSS. 8. The payments for interest and discount will not be made from the MSS Account. The receipts due to premium and/or accrued interest will not be credited to the MSS Account. Such receipts and payments towards interest, premium and discount would be shown in the budget and other related documents as distinct components under separate sub-heads. The Treasury Bills and dated securities issued for the purpose of the MSS would be matched by an equivalent cash balance held by the Government with the Reserve Bank. Thus, there will only be a marginal impact on revenue and fiscal balances of the Government to the extent of interest payment on Treasury Bills and/or dated securities outstanding under the MSS. It may be recalled that an Internal Working Group on Instruments of Sterilisation had submitted its Report in December 2003. Following the recommendations contained in the Report, the Government of India had confirmed its intention to strengthen the Reserve Bank in its ability to conduct exchange rate and monetary management operations in a manner that would maintain stability in the foreign exchange market and enable it to conduct monetary policy in accordance with its stated objectives. On February 23, 2004, the Reserve Bank had announced the launching of the Market Stabilisation Scheme

Impacts of MSS The question at this stage is whether the market is ready to receive market stabilisation bonds (MSBs). MSBs are treasury bills and dated securities issued under market stabilisation scheme (MSS) to soak excess money market liquidity stemming from dollar purchases by Reserve Bank of India (RBI). The market is worried about the liquidity in the system, postbonds. In the past, whenever the call rates were higher and the liquidity in the system was tight, the RBI had partially accepted the bids under LAF, to ensure sufficient liquidity. We have also witnessed huge (about Rs 140,000 crore per year), but well-

managed government borrowing programmes, completed during the past three years. Despite the magnitude of these borrowings, there were occasions when market participants queued up before the RBI, even before the office opened, to bid in open market operation sales. Therefore, the size, timing and tenor of MSBs would also be managed without any liquidity concerns provided RBI maintains stable interest rate. It is also worth noting that MSBs may not necessarily propel yields upwards under such circumstances. However, there are strong indications that interest rates are unlikely to remain stable. Analysts point out that the economic growth is around the corner, non-food credit is picking up and inflation might descend only to 5 per cent. In fact, yields started moving up in the five-year segment to 5.10 per cent (February 2004) from 4.90 per cent (December 2003). As yields go up, there will be demand for short-term papers. MSBs are expected to be of short-term maturity and hence there will be demand for MSBs. The effect of MSBs on the bond market can be seen in light of the supply and demand for government securities. Government borrowing for the next fiscal year 2004-05 is expected to be lower in the first quarter compared to corresponding period previous year, because of the surplus cash carried forward from this fiscal year. Hence fresh gilts supply is going to be lower and auctions fewer, at least in the first quarter of 2004-05. Moreover, Rs 49, 353 crore of gilts would mature in March 2004-October 2005. While the supply of fresh gilts will shrink, provident funds will increase their investment in sovereign paper. Multilateral development banks such as the Asian Development Bank and the International Finance Corporation have been permitted to invest in gilts. And banks "" such as the State Bank of India "" looking to invest in the medium term, display enough appetite for them. In such an environment, MSBs, which will have all the attributes of the existing treasury bills and dated securities, would be a better alternative for investment in the absence of sufficient supply of government paper. The average amount parked in daily and 14-day repos is at present over Rs 40, 000 crore. As a fallout, 50 to 75

percent of the gilts auctioned in recent times have been cornered by two or three big players, ostensibly due to lack of better deployment avenues. This phenomenon could be perceived as one of the factors that contributed to drive down the yield on 10-year paper to below 5 per cent levels. Therefore it is an opportune time for MSBs to arrive. Welcome MSBs. Another vista for Mint Road Amit Tandon Managing Director, Fitch Ratings India Pvt Ltd The recent agreement reached by the Reserve Bank of India (RBI) with the government over the market stabilisation scheme (as envisaged by the RBI's working group on instruments of sterilisation) expands the menu of approaches available to the apex bank for management of capital flows. Seen in the context of other measures taken by the RBI to liberalise capital outflows (including inter alia expanding the automatic route of foreign direct investment, permission to residents to invest abroad up to specified limits etc) and moderate capital inflows, the move to issue market stabilisation bonds (MSBs) draws upon the experience of other countries in managing capital flows through a combination of market-based instruments for sterilisation, liberalisation of capital outflows and control on inflows. Notably, the People's Bank of China, China's central bank, started sterilising capital flows through issue of central bank bills (an option considered but not recommended by the RBI working group in the Indian context) in 2003. Similar measures for management of capital flows have also been taken in Thailand and Taiwan. The structure of the market stabilisation scheme takes adequate care to ensure that the proceeds from the issue of MSBs are not used to fund the fiscal deficit. The amount raised through the issue of MSBs would be credited to a separate fund maintained and operated by the RBI in consultation with the government. The fund would not be available for regular government expenses. The issuance of MSBs will considerably augment the RBI's ability to conduct foreign exchange and monetary management operations and help overcome the constraints posed by the depletion in its holdings of government securities. Importantly, however, as mentioned in the working group's report, the RBI intends to use the MSBs to absorb only the "enduring" component of surplus liquidity and, consequently, the MSBs would complement the normal instruments of day-to-day liquidity management viz the liquidity adjustment facility and normal open market operations. The central bank will decide and notify the amount, tenure and timing of issuance of such treasury bills and dated securities. Whenever such securities are issued by the RBI for the purpose of market stabilisation and sterilisation, a press release

at the time of issue would indicate such purpose. The total absorption of liquidity from the system by the RBI will continue to be in line with the monetary policy stance from time to time and accordingly, the liquidity absorption will get apportioned among the instruments of liquidity adjustment facility, market stabilisation scheme and normal open market operations. Consequently, while tackling surplus liquidity the timing and conduct of stabilisation bond issuances is likely to take into account prospects for credit growth, affirm the current "soft and flexible" policy stance with respect to interest rates and continue with the policy of "smoothening" currency movements as opposed to a more interventionist approach.