Last week, I met little Sam. He is a school student, and doesn’t 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. That’s 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, 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 doesn’t 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, 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 isn’t 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