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Why does RBI issue or buyback government bonds? | TNMG: The Next Marketing Guru

TNMG: The Next Marketing Guru

Why does RBI issue or buyback government bonds?

Posted on January 26, 2010 by Guest Author

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Last week, I met little Sam. He is a school student, and doesnt understand Finance much. But some day he wants to make it big in
Finance, because he has heard that Finance has got something to do with mathematics, and he loves it. Thats not a bad reason at
all, at least to start with, I thought.
Sam knows that bonds pay pre-fixed returns, unlike equities. He wanted to know something about bond mathematics and about bond
trading strategies. He knew that corporate issue bonds because they need money for their projects, and operations. Little Sam also
knew that government bonds are less risky than corporate bonds because governments can print money and pay back bondholders
any time they want.
I told him that it is the central bank of a country (in case of India, it is RBI) that issues government bonds. They issue bonds in the
primary market to the primary dealers. There are 19 primary dealers in India at present; they are large banks and other financial
institutions like Bank of Maharashtra, Canara Bank, Bank of Baroda, Merrill Lynch, Nomura and so on. For longer maturity bonds,
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Why does RBI issue or buyback government bonds? | TNMG: The Next Marketing Guru

they can re-issue it many a times throughout their maturity, all in primary market. There are numerous players in the secondary
market who can buy and sell the bonds among themselves after the issue. Sometimes, RBI may also like to buyback a bond, before
its maturity.

Do you know why does RBI issue or buyback government bonds? I asked. Sam replied quickly, Just like corporate, they also need
money. You are partially right, I continued RBI can also control our economy to an extent through issuing or buying back bonds.
Just see if it doesnt follow from simple logic and common sense.
1. When RBI issues (or re-issues) bonds, money flows from primary dealers to RBI. This decreases money in the hands of the
banks, and hence open money in the system, and hence reduces liquidity in various markets.
2. When there is less amount of money in the hands of the banks, they will be less willing to lend, and more willing to borrow. So,
the lenders will charge more from the borrowers. So, the call money market rate will increase. Call money market rate in India is
the interest rate charged against call money (money lent for 1 day).
3. Similarly, other short term interest rates will also increase. Because of the increase in short term interest rates, long term rates
will go up according to both pure expectation theory and liquidity preference theory (two theories I promised to teach Sam some
other day).
4. As the long term interest rates rise, investors willingness to take loans for the purpose of investment comes down. Similarly,
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Why does RBI issue or buyback government bonds? | TNMG: The Next Marketing Guru

consumers are less likely to take loans for purchase of houses, vehicles etc. So, both investment and consumption will come
down.
5. Also, as there is less amount of open money in the system, other things remaining unchanged, Indian Rupee (INR) becomes
costlier (appreciates) in the foreign exchange market.
6. With appreciation of INR in the foreign exchange market, Indian exporters are less willing to export goods and services because
they now get less amount of INR for fixed amount of foreign currencies that they get from exports.
7. Thus, all of investment, consumption and net exports decrease, thereby reducing the aggregate demand. This decrease in
aggregate demand in turn reduces inflation, employment and real GDP.
The greater the amount of the issue, the greater is the impact. On the other hand, Government securities buyback by RBI will have
the exact opposite effect. Thus, a buyback will reduce interest rates, increase consumption, investment, and net exports; and hence
will result in increases in inflation, employment and real GDP. The decision of whether to issue or buyback bonds, and by what
amount, is taken by RBI keeping the trade-off between inflation, employment and real GDP and their target figures in mind. But isnt
what you said more of macroeconomics than finance? Why should I know these things? little Sam seemed curious. As a pilot needs
to know the airport runway, a good trader in government bonds should know this piece of macroeconomics I replied.

This article is authored by Ritwick a senior analyst with a globally reputed investment bank. Ritwick has completed
his MBA (Finance) from a top B-School in India. His hobbies include solving puzzles and playing chess. He writes mainly on Finance.
You can contact him at ritwickchowdhuri@yahoo.com

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10 THOUGHTS ON WHY DOES RBI ISSUE OR BUYBACK GOVERNMENT BONDS?
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Why does RBI issue or buyback government bonds? | TNMG: The Next Marketing Guru

tumpa
on January 26, 2010 at 7:28 PM said:

Ritwick, this made my life a lot easier. Had forgotten both Macroeco & finance..Thanx a ton

AK
on January 28, 2010 at 6:54 PM said:

Really nice input.

AKK
on January 29, 2010 at 4:48 AM said:

I must say, continue this good work buddy

Susmi
on January 29, 2010 at 9:31 AM said:

This is a really enlightening article

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Morton Kirkpatric
on February 1, 2011 at 9:49 PM said:

There is clearly a whole lot to know about this. I think you created some great points in Characteristics also.
Keep working , great career!

Jennette Balle
on September 9, 2011 at 3:20 AM said:

Hello may I reference some of the information here in this site if I reference you with a link back to your site?

ANR
on January 10, 2012 at 2:44 PM said:

Simplicity is the key

website
on May 26, 2012 at 11:25 AM said:

Jesus Christ there is plenty of spammy feedback on this site. Have you actually thought about attempting to eliminate them or
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installing a plugin?

Samir
on May 2, 2013 at 5:41 PM said:

Really good post Ritwick !!!

Kamal mathur
on August 21, 2013 at 9:22 AM said:

I really helped by this article to understand the zigs of finance

which I tought during studying sp. I M pandey. Although it is very old article but still valid for today as well.

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