Bonds indicate fear of the future. RBI soothes.

The Governor of the Reserve Bank had no business criticising the Long Term Capital Gains tax on shares in this year's budget, wrote A Nageswaran. "When asked to comment on whether the investment slowdown in India had ended, he said India faced five different taxes on capital, including the tax on long-term capital gains, and that this state of affairs would certainly affect investment. Thus, the governor made an unacceptable foray into fiscal policy, which is the domain of the elected government." Nageswaran believes that not taxing capital gains on shares is a handout to rich people, and is an easy way to finance the fiscal deficit, 96% of which was used up by the end of October. And therein lies the problem. The Reserve Bank has no say in government spending but has been ordered to target a retail inflation rate of 4% by the government. While the RBI struggles to contain high consumer prices in India, central banks in developed countries are under attack for being unsuccessful in raising inflation to their target of 2%, wrote Prof B Eichengreen. It is easy to criticise the RBI but how do you control the bond market? Bond prices dropped and yields rose by 3% at the conclusion of the budget speech, in expectation of rising fiscal deficit and retail inflation. The State Bank of India reported its first quarterly loss in 17 years, partly to account for its non-performing assets and partly because of the fall in the value of its bond portfolio. High bond yields mean that any fresh government borrowing will have to be at higher interest rates. Banks are required to invest in government securities under the Statutory Liquidity Ratio which is presently set at 19.5%. In the absence of investment opportunities banks hold government securities in excess of SLR. Banks are predicted to lose Rs 305 billion collectively in this financial year, with public sector banks taking a bigger hit. After the RBI meeting bond prices cooled somewhat, showing that markets approved of its policy. Since public sector banks are owned by the government it has to bail them out of their bad loans. Handing out large dollops of cash will add to fiscal deficit and increase borrowing so the government has devised a circular plan, in which it will borrow money from banks in exchange of bonds and then pay the money back in lieu of shares in the same banks. Banks will then use this money to write off their debts. Unfortunately, banks will be forced to return this money to the government in the form of dividends, which will reduce fiscal deficit. Whether banks will be left with any money for lending for new investments after this elaborate flim-flam has not been explained. Politicians engage in trickery. Thankfully the RBI is honest.