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Monday, September 08, 2008

The oil subsidy is causing an indigestion

by Jeetendra.

The problems caused by the oil pricing policy are becoming daily more apparent. For the past few weeks, there have been reports of long lines at diesel pumps, particularly in Chennai and Pune, and electricity shortages. Writing in Business Standard, Urjit Patel points out that the problems of oil pricing are not confined to the energy sector -- they extend all the way to the financial and currency markets. And the attempts to solve these problems are only creating new problems.

The problem: oil companies are short of money

The fundamental problem is that the price controls are causing upstream oil companies to bleed cash, since they have to pay world prices for their petroleum imports but can only collect a fraction of these prices at domestic pumps. For some time, they have temporised by borrowing from banks. But now they have hit their credit limits. So, they need a cash infusion, quickly.

Solution: give the oil companies "government oil bonds"

A simple solution to the problem could have been this: government could have compensated the oil companies for their "underrecoveries" with regular government bonds. Then, the oil companies could have sold the bonds in the market, converted the rupees into dollars, and used the dollars to buy crude oil. But the government didn't do this. Instead, it created special "government oil bonds", which the oil companies have been unable to sell, at least not for anywhere near their face value.

Why are banks demanding such large discounts on these bonds? On the face of it, this seems very strange. After all, the oil bonds are IOUs from the government, and will surely be honored in full. The answer: these bonds, unlike regular government bonds, are not "SLR eligible". Which means banks cannot use them to fulfill their Statutory Liquidity Ratio (SLR) requirement. Nor can the banks discount these bonds at the RBI, in case they themselves need cash. So, the banks don't want them. Which means the oil companies are stuck.

Problem: the bond market is segmented

Why did the RBI choose to create a special oil bond, forcing a segmentation of the bond market? The answer, most likely, is that this was done to contain the fiscal deficit.

The huge oil subsidies are putting tremendous pressure on the government budget, imperiling the fiscal targets. Paying the subsidies by issuing bonds has the signal advantage that such spending is kept off budget. But it has the disadvantage of increasing the government's interest expenses. Expenses increase because the amount of government debt increases. Then, they could go up some more because the increase in government debt might lead to a rise in interest rates. It's a simple matter of supply and demand: the higher the supply of bonds, the lower the bond price -- which means the higher the interest rate.

By making oil bonds a separate category, not eligible for the SLR, the RBI could preserve demand and supply in the regular bond market. Banks would ignore the oil bonds and bid aggressively for regular government bonds to meet their SLR requirements, thereby keeping interest rates low and keeping the government interest burden down.

But this "solution" created two new problems. First, it segmented the government bond market. There are now two completely different prices for government bonds, depending on whether they are SLR-eligible or not. This is a major impediment to market efficiency and development. For how can private firms price their bonds accurately, when even government bonds for similar maturities have two different prices?

The second problem is that the special oil bonds failed to solve the original problem. The oil companies still need cash.

Solution: RBI's Special Market Operations scheme

The RBI then responded by creating the Special Market Operations (SMO) scheme. Under the SMO, the central bank purchases the bonds from the oil companies, in exchange for foreign currency from its reserves. That way, the oil companies can unload the paper they don't want, and get the foreign exchange they need to pay for their imports.

Problem: Undermining monetary policy

Urjit argues that the SMO doesn't really solve the problem. It just shifts it to the central bank. After years of effort to clean up the RBI's balance sheet, the central bank is now getting stuck with illiquid government bonds. That's a problem because the essence of modern central banking is exchanging one liquid asset for another. When the economy is short of money, central banks buy bonds and inject cash. When the economy has too much money, it does the reverse. In both cases, central banks need paper that can be readily bought and sold.

It is true that central banks do occasionally buy illiquid paper. In fact, the US Fed and the ECB are doing this right now. That's because they're facing a financial crisis, forcing them to help out financial institutions in order to safeguard the overall system. That's one of their core responsibilities.

But India has no financial crisis.

Also, when central banks do purchase illiquid paper, they normally demand large discounts. This has not been done with SMO. Indeed, the whole point of the exercise was to ensure the opposite -- that the oil companies did not have to suffer a "haircut" when selling the bonds into the market.

Problem: Undermining exchange rate policy

Besides affecting the RBI's balance sheet, a further problem with the SMO is that it distorts exchange rate policy. The scheme has forced RBI to channel foreign exchange not to the market in general, but to specific companies. Again, this is a retreat from the efforts to create a modern, market-friendly, and firm-neutral approach. This is not a minor retreat. So far, the central bank has swapped no less than $4.4 billion under the SMO, and there are reports that further swaps are in the offing.

There is no free lunch

Problems of a few percentage points of GDP cannot be wished away! Oil subsidies, sounded, at first, like a `mere' distortion of the oil sector. But such magnitudes are very hard to digest, and inexorably impinge on monetary and fiscal policy. The price controls are distorting market prices for bonds and foreign exchange, undermining financial and currency market development, and reversing progress toward a modern central bank.

We started with the core problem: price controls. Then, there had to be special bonds, with a forced fragmentation of the bond market. Then, the SMO had to be created, undermining monetary and exchange rate policy. We keep scrambling from one problem to the next. One can only imagine the amount of staff time at MOF and RBI that has been wasted on this. It would have been better utilised doing genuine economic reforms.


  1. Jeetendra,

    Sounds like an arbitrage opportunity to me. Suppose the non-SLR bonds with oil companies run at a 1% discount to SLR-eligible GOI bonds. All else is the same; they both have riskless cashflows. Then would not non-bank financial firms and individuals -- people like mutual funds who are not force-fed government bonds - love to sell GOI bonds in their portfolios and switch to these new oil bonds? Such actions would tend to push the price of SLR-eligible bonds down and the price of oil bonds up.

  2. Arbitrage doesn't work because the two types of bond are *not* the same. They have the same credit risk, but not the same characteristics. So, one wouldn't expect the prices to equalize.

    Now, it is true that the insurance companies don't care about SLR-eligibility per se, becaue they aren't subject to the SLR. So, you might think that they'd step in and snap up the bonds, if their price falls below that of regular government bonds. But they don't. That's because the insurance companies care about another characteristic of the oil bonds: their lack of liquidity. They know if they would ever have to sell the bonds, they would have a hard time selling them to the banks (the other major player in the
    bond market) and could suffer huge capital losses. So, they don't want to buy the bonds in the first place.

  3. Wasn't GoI in fact guided by the RBI in issuing these "oil" bonds as opposed to plain vanilla bonds? The RBI's reasoning was that it did not want these bonds creating "excess liquidity" in the (domestic) system. Now I can't pretend to understand what "excess liquidity" is, but that the OMCs would be unable to cash these bonds easily is fully in keeping with RBI's plan. Oil bonds, in other words, were meant to be funny money by design. I'm willing to bet, therefore, that should someone in fact discover an arbitrage opportunity and equalize the prices with regular bonds, the RBI will step in and right the situation pronto.

  4. True, the GOI was guided by the RBI. And true, the RBI knew that the oil bonds were "funny money". But "excess liquidity" wasn't their concern; the fiscal deficit was.

    The reason is that when an oil company sells a bond, it doesn't create any liquidity (cash). It gets cash, to be sure, but at the same time someone else loses that cash and gains a bond. So, the total amount of money stays the same. All that happens is that the cash is moved around the economy. The RBI doesn't care about that.

    But the RBI does care about the interest rates the government pays on its debt! The SLR exists to create an artificial demand for government debt, so that the deficits can be financed at low interest rates. And the RBI was determined that the new oil bonds shouldn't disturb this supply-demand equilibrium. That's why it issued "funny money" bonds.

  5. Jeetendra,

    1. Concerns over RBI Balance Sheet:
    News: Feb 15, 2008 "Finance Ministry has agreed to give SLR status to oil bonds this fiscal," Petroleum Secretary M S Srinivasan told reporters today”
    I believe that this has not been implemented as of now but there have been talks about changing the status of Oil Bonds
    The liquidity of Oil bonds in secondary market will increase once Banks are allowed to consider such Oil Bond for SLR purpose.

    2. Oil Companies are also looking at alternative routes to Liquidate Oil Bonds in Secondary market.
    “Indian Oil Corporation Limited (IndianOil) has successfully liquidated Rs. 985 crore worth of oil bonds maturing in 2015 in the secondary market trade today through the book-building route. The issue size was Rs. 250 crore with a green shoe option and generated a very good response. The arrangers to the issue were M/s. A.K. Capital Services Ltd., M/s. Allianz Securities Ltd., M/s. Centrum Capital Limited, M/s. ICICI Securities Ltd. and M/s. UTI Bank Ltd.”

  6. Really found your article worth reading..Can you please let me know why are these Oil Bonds " Off Balance Sheet" items for GOI even though GOI is definitely going to pay them at their maturity..


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