By next month, the government is expected to make good one of its key Budget announcements and issue guidelines to buy back a massive Rs 40,000-crore (Rs 400 billion) worth of high-cost debt from public sector banks.

Not unexpectedly, the gilts market is jittery; a buyback of this magnitude could well distort yields that have been steadily dropping from their highs of a few months ago.

But the consensus in North Block and Mint Street is that, despite the apprehensions, many public sector banks with substantial gilts portfolios and huge non-performing assets could have little choice but to participate in the programme, despite its voluntary nature.

A senior finance ministry official put it rather cynically: "Which chairman would not like his public sector bank to post extraordinary profits during his tenure?"

What the official has left unsaid is that the Centre stands to gain enormously from bank compliance as well. In short, it's a win-win situation for both parties. To understand that, a little background first.

To finance its fiscal deficit, the Centre, through the Reserve Bank of India, borrows every year from the market. In the past, the inability to control the deficit has forced it to borrow at rates as high as 13 or 14 per cent, more than double the prevailing interest rates.

Much of the government's borrowings were lapped up by public sector banks. Today, almost three-fourth of the government's Rs 6,73,690 crore (Rs 6,736.90 billion) worth of outstanding domestic debt as on March 13, 2003, is held by banks.

Unfortunately, none of the earlier high-cost debt issues had call or put options to enable the Centre to buy them back at a later date. It was only in July 2002 that the RBI issued a bond with put and call options that can be exercised on or after five years from the date of issue.

And over 75 per cent of the government debt bears an interest rate of 9 per cent and above. Overall, the weighted average cost of outstanding government securities is as high as 10.2 per cent. Over the past two or three years, on the contrary, softer interest rates have enabled the Centre to borrow at between 6 and 7 per cent.

After mulling over the debt buyback plan for over a year, the finance ministry finally decided to swap Rs 40,000 crore of its high-cost debt with securities carrying lower rates. It has set its eyes on debt that is not just high cost but also rarely traded.

Surprising as it may seem, of the 116 securities in the market, just about a dozen are traded every day.

This is well illustrated by the fact that just 20 securities accounted for over 85 per cent of total secondary market transactions in the gilts market last fiscal.

Under the buyback plan, the RBI is likely to pick and choose securities that have a residual maturity of at least five years.

To generate maximum savings for the government, the RBI might pick those securities that not only have huge outstandings but also high interest rates.

Finance ministry officials say that once a security is identified, the banks will be asked to bid or quote a price at which they will sell. The Centre or the RBI will not specify the buyback price.

The difference between the market price and the quoted price will reflect the cost of illiquidity and the benefit of income tax exemption accruing to the banks.

The programme is likely to be spread throughout the year, but the window for the buyback of each security will be kept open for a short while to preclude the panic that could follow if a one-shot buyback programme were held.

It is possible, however, that the RBI might limit the buyback programme to the end of the year for at least one important reason: the Centre's borrowing programme will be complete so the distortion on the yield curve will be minimal.

To avoid any adverse impact on the fiscal deficit, it is almost certain that the Centre will replace the high-cost securities with new sovereign bonds carrying lower rates. There will be no cash compensation.

If the Centre decides to pay a part of the premium on the high-cost securities in cash, it would help bolster market sentiments. But a cash payment will mean a higher deficit, which is a taboo in North Block.

Banks can, however, derive comfort since the RBI might be generous with the issue of floating rate bonds in the debt-swapping exercise. This will allow the banks to hedge interest rate risks better, should the rates harden in the near future.

How does the Centre benefit? And what about banks? Take for instance, the 12 per cent GoI 2008 gilt that would be an ideal security for the Centre to buy back from banks.

The outstanding amount on this instrument in March 2003 was Rs 12,000 crore (Rs 120 billion). It has a residual maturity of five years and carries a cost almost double the prevailing rate of 6.30 per cent.

The Centre can halve its interest outgo on this security -- from Rs 1,440 crore (Rs 14.40 billion) every year at 12 per cent to Rs 720 crore (Rs 7.20 billion) at 6 per cent -- if it replaces this security by a fresh security bearing the current rates.

Over the next five years, the savings could be as huge as Rs 3,600 crore (Rs 36 billion) in absolute terms. This may be distorted since one has to bring it to present value using an appropriate discounting factor.

But buying back entails its own cost. The 12 per cent GoI 2008 trades at a premium of over Rs 30 per Rs 100 share. Its purchase price on April 18, 2003 stood at Rs 131.13. Since gilt yields have fallen sharply over the past couple of years, the price of the high-interest paying 12 per cent GoI 2008 is also higher.

This means the Centre will have to pay about Rs 3,735 crore (Rs 37.35 billion) more (or Rs 15,735 crore -- Rs 157.35 billion -- in all) to buy it back fully from the market today.

But the Centre will ask for its pound of flesh. The scrip described above is relatively illiquid. This security accounted for only 0.36 per cent of total turnover in the secondary market last fiscal. So the finance ministry and the RBI will not be willing to buy it back at Rs 131.13.

Given the negligible opportunity public sector banks have to sell this security and book profits, the Centre might ask for an illiquidity premium. That is, it will be willing to buy back the security only at a discount to the market price.

A finance ministry official made that much clear when he said, "What's in it for the Centre if it buys back securities at prevailing market prices?"

Also, Jaswant Singh announced that profits booked through sale of illiquid securities under the debt buyback plan and subsequently used for non-performing assets provisioning will be exempt from corporate tax. The Centre will, in fact, gun for a further lower price since the banks will benefit from the income tax exemption too.

The Centre, thus, benefits on two counts: from lower interest payments during the residual maturity and from paying a discount to the market price of the security.

As far as the banks are concerned, they will be able to book significant profits by selling their illiquid securities.

Given the gross NPA levels of all the public sector banks -- Rs 56,507 crore (Rs 565.07 billion) in March 2002 or 11.1 per cent of gross advances -- it would only make sense for them to book profits and claim income-tax exemptions by using the money for NPA provisioning.